filings.toolsItem 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from the results discussed in the forward-looking statements. Factors that might cause a difference include, but are not limited to, those discussed under Item 1A. Risk Factors in this Annual Report on Form 10-K. The following section is qualified in its entirety by the more detailed information, including our consolidated financial statements and the notes thereto, which appears elsewhere in this Annual Report.
Overview
Organization
We are a leading global provider of security products and solutions operating in three geographic regions: Americas, EMEA and Asia Pacific. We sell a wide range of security products and solutions for end-users in commercial, institutional and residential markets worldwide, including the education, healthcare, government, hospitality, commercial office and single and multi-family residential markets. Our leading brands include CISA, Interflex, LCN, Schlage, SimonsVoss and Von Duprin.
Recent Developments
COVID-19 Pandemic
In March 2020, a global pandemic was declared by the WHO related to COVID-19. The impacts of the COVID-19 pandemic negatively affected the global economy, disrupted supply chains and created significant volatility and disruption in financial markets. The outbreak and spread of COVID-19 also resulted in a substantial curtailment of business activities worldwide, including the major geographic markets we serve. As part of the efforts to contain the spread of COVID-19, federal, state and local governments have imposed various restrictions on the conduct of business and travel, such as stay-at-home orders, travel restrictions and quarantines. These measures, as well as changes in employee health and safety concerns and consumer spending patterns, trends and preferences, have led to widespread business closures and lower demand for our products, with the most pronounced negative impacts of these measures on our results of operations occurring during the second quarter of 2020. Further, changes in commercial real estate occupancy, constraints on government and institutional budgets and the uncertain business climate have led to declines and delays in new construction activity and discretionary projects, including in many of the commercial and institutional construction markets we serve.
As the pandemic and resulting economic challenges have adversely impacted, and will likely continue to adversely impact us, we continue to closely monitor their effects on all aspects of our business and the markets in which we operate. Throughout the pandemic, our primary focus has been, and continues to be, the health and safety of employees, our business continuity plan, meeting the evolving needs of our customers and the well-being of the many communities around the world in which we operate. During the early months of the pandemic, we experienced temporary production shut-downs due either to government mandate or to help ensure employee safety, most notably in Italy and the Baja region of Mexico. However, the vast majority of our manufacturing facilities have remained open and operational throughout 2020, in part due to the numerous health and safety measures we adopted to promote the health and safety of our workforce and because many of our global operations have been deemed essential businesses. All of our global production and assembly facilities were operational as of December 31, 2020, and while we currently expect they will remain operational for the foreseeable future, such expectation is dependent upon future governmental actions, demand for our products, the stability of our global supply chain and our ability to continue to operate in a safe manner.
We remain focused on business continuity and ensuring our facilities remain operational where safe and appropriate to do so. We will also continue to serve our customers when needed through our channel partners or inventory on hand. To the extent any additional temporary closures or adjustments to production are necessary, such measures will be implemented in a way that allows us to resume operations in an efficient and safe manner, while also minimizing disruption to customers and our overall business, including prudent measures to mitigate, to the extent possible, any financial impacts, although any additional local orders or decrees resulting in new temporary shut-downs will drive further unfavorable impacts to our operations, ability to serve our customers and potentially, our financial position and liquidity. The pandemic will likely continue to impact us in numerous and evolving ways that we may not be able to accurately predict; however, we will continue to closely monitor its impact on our business, employees, customers, suppliers, distribution channels and other business partners, and we believe that our actions taken to date, our financial flexibility and potential measures within our control will allow us to maintain a sound financial position and provide for adequate resources to fund our ongoing operating and financing needs.
Additionally, as a response to the COVID-19 pandemic, on March 27, 2020, the Coronavirus Aid, Relief and Economic Security Act (the "CARES Act") was enacted and signed into law, which included measures to assist companies in response to the COVID-19 pandemic. One measure allowed companies to defer the remittance of the employer portion of the social security tax through December 31, 2020, with half the amount deferred required to be paid by December 31, 2021, and the other half by December 31, 2022. Through December 31, 2020, we have elected to defer approximately $13 million under this provision, which is classified in Accrued expenses and other current liabilities and Other noncurrent liabilities within our Consolidated Balance Sheet. A second measure of the CARES Act raised the limit on business interest deductions from 30% to 50% of adjusted taxable income for tax years 2019 and 2020. This increased interest limitation resulted in approximately $20 million of reduced cash tax payments in 2020. Each of these two measures has resulted in a benefit to our cash flows from operations for the year ended December 31, 2020; however, neither measure is expected to materially impact our effective tax rate, and no income tax effects have been recorded during the year ended December 31, 2020.
The challenges and uncertainties related to the COVID-19 pandemic and its potential impact on our business, results of operations, financial condition and cash flows, as well as a number of other challenges and uncertainties that could affect our businesses are described further under Part I, Item 1A. "Risk Factors."
2020 and 2019 Significant Events
Acquisitions
In December 2020, we acquired Yonomi, Inc. ("Yonomi), a U.S. based smart home integration platform provider and innovation leader in IoT Cloud platforms. Yonomi has been integrated into our Americas segment.
Impairment of Goodwill and Intangible Assets
As a result of the global economic disruption and uncertainty due to the COVID-19 pandemic, we performed interim impairment tests on the goodwill balances of our EMEA and Asia Pacific reporting units, as well as on certain indefinite-lived trade name assets in these two regions, during the first quarter of 2020. As discussed in Notes 5 and 6 to the Consolidated Financial Statements, the results of these interim impairment tests indicated that the estimated fair value of our Asia Pacific reporting unit and three indefinite-lived trade names were impaired. Consequently, goodwill and intangible asset impairment charges totaling $96.3 million were recorded.
Further impairment charges were recorded in our Asia Pacific segment during the year ended December 31, 2020, including $2.6 million related to supply chain disruptions that reduced a brand's expected future cash flows and $2.8 million related to declines in volumes and pricing pressure for a separate subsidiary in the region.
Loss on Assets Held for Sale
The assets and liabilities of our QMI business met the criteria to be classified as held for sale as of December 31, 2020. Accordingly, QMI's net assets, which primarily included working capital and long-lived assets, were written down to fair value, estimated based on expected sales proceeds, less cost to sell, resulting in a Loss on assets held for sale of $37.9 million.
Turkey and Colombia Divestitures
In 2019, we closed our production facility in Turkey to help streamline our footprint in EMEA and subsequently sold certain of the production assets, which represented a business, for total proceeds of approximately $4.1 million. We recorded a loss on divestiture of $24.2 million ($25.5 million, net of tax), primarily driven by the reclassification of $25.0 million of accumulated foreign currency translation adjustments to earnings upon sale. We also sold our interests in our Colombia operations in 2019 for a nominal amount, recording a net loss on divestiture of $5.9 million, of which $1.2 million related to the reclassification of accumulated foreign currency translation adjustments to earnings upon sale.
2020 Dividends and Share Repurchases
We paid quarterly dividends of $0.32 per ordinary share to shareholders on record as of March 17, 2020, June 16, 2020, September 16, 2020, and December 16, 2020. We paid a total of $117.3 million in cash for dividends to ordinary shareholders and repurchased approximately 1.9 million shares for approximately $208.8 million during the year ended December 31, 2020.
Other Financing Activities
In 2019, we issued $400.0 million of 3.500% Senior Notes due 2029 (the "3.500% Senior Notes"). Net proceeds from the issuance of the 3.500% Senior Notes, along with cash on hand, were utilized to make a $400.0 million principal payment to partially pay down the Company's outstanding term loan facility (the "Term Facility") balance. As a result of this payment, we have satisfied our obligation to make quarterly installments on the Term Facility up to its maturity date, with the remaining outstanding balance of $238.8 million due on September 12, 2022.
Subsequent Event
Effective January 1, 2021, we have combined our EMEA and Asia Pacific operations into a new segment named Allegion International, in addition to renaming our Americas segment "Allegion Americas". The new Allegion International segment has been created to drive speed and efficiency, simplify our operating segments and optimize our non-U.S. operations.
Results of Operations - For the years ended December 31
| Dollar amounts in millions, except per share amounts | 2020 | % of Net revenues | 2019 | % of Net revenues | ||||||||||||||||||||||||||||||||||
| Net revenues | $ | 2,719.9 | $ | 2,854.0 | ||||||||||||||||||||||||||||||||||
| Cost of goods sold | 1,541.1 | 56.7 | % | 1,601.7 | 56.1 | % | ||||||||||||||||||||||||||||||||
| Selling and administrative expenses | 635.7 | 23.4 | % | 681.3 | 23.9 | % | ||||||||||||||||||||||||||||||||
| Impairment of goodwill and intangible assets | 101.7 | 3.7 | % | 5.9 | 0.2 | % | ||||||||||||||||||||||||||||||||
| Loss on assets held for sale | 37.9 | 1.4 | % | — | — | % | ||||||||||||||||||||||||||||||||
| Operating income | 403.5 | 14.8 | % | 565.1 | 19.8 | % | ||||||||||||||||||||||||||||||||
| Interest expense | 51.1 | 56.0 | ||||||||||||||||||||||||||||||||||||
| Loss on divestitures | — | 30.1 | ||||||||||||||||||||||||||||||||||||
| Other (income) expense, net | (13.0) | 3.8 | ||||||||||||||||||||||||||||||||||||
| Earnings before income taxes | 365.4 | 475.2 | ||||||||||||||||||||||||||||||||||||
| Provision for income taxes | 50.9 | 73.1 | ||||||||||||||||||||||||||||||||||||
| Net earnings | 314.5 | 402.1 | ||||||||||||||||||||||||||||||||||||
| Less: Net earnings attributable to noncontrolling interests | 0.2 | 0.3 | ||||||||||||||||||||||||||||||||||||
| Net earnings attributable to Allegion plc | $ | 314.3 | $ | 401.8 | ||||||||||||||||||||||||||||||||||
| Diluted net earnings per ordinary share attributable to Allegion plc ordinary shareholders: | $ | 3.39 | $ | 4.26 |
The discussions that follow describe the significant factors contributing to the changes in our results of operations for the years presented and form the basis used by management to evaluate the financial performance of the business. For a discussion of our results of operations for the year ended December 31, 2019, compared to the year ended December 31, 2018, see “Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our 2019 Annual Report on Form 10-K filed with the SEC on February 18, 2020.
Net Revenues
Net revenues for the year ended December 31, 2020, decreased by 4.7%, or $134.1 million, compared to the same period in 2019, due to the following:
| Pricing | 1.0 | % | |||
| Volume | (5.8) | % | |||
| Divestitures | (0.3) | % | |||
| Currency exchange rates | 0.4 | % | |||
| Total | (4.7) | % |
The decrease in Net revenues was principally driven by lower volumes across all regions, primarily due to the economic challenges stemming from the ongoing COVID-19 pandemic, particularly during the second quarter of 2020. The decrease was, to a lesser degree, due to the impact of the divestitures of our Colombia and Turkey businesses in 2019, as discussed above. These decreases were slightly offset by improved pricing and the impact of foreign currency exchange rate movements.
Pricing includes increases or decreases of price, including discounts, surcharges and/or other sales deductions, on our existing products and services. Volume includes increases or decreases of revenue due to changes in unit volume of existing products and services, as well as new products and services.
Cost of Goods Sold
For the year ended December 31, 2020, Cost of goods sold as a percentage of Net revenues increased to 56.7% from 56.1%, due to the following:
| Inflation in excess of pricing and productivity | 0.2 | % | |||
| Volume / product mix | 0.8 | % | |||
| Divestitures | (0.1) | % | |||
| Currency exchange rates | (0.2) | % | |||
| Restructuring expenses | (0.1) | % | |||
| Total | 0.6 | % |
Costs of goods sold as a percentage of Net revenues for the year ended December 31, 2020, increased primarily due to the impact of reduced volumes and product mix and, to a lesser extent, inflation in excess of pricing and productivity. Inflation in excess of pricing and productivity was driven by productivity challenges stemming from the temporary closures during the second quarter discussed above; labor inefficiencies, such as increased absenteeism; and, increased costs related to ensuring a safe and healthy work environment in light of the COVID-19 pandemic. These increases were partially offset by certain non-U.S. government incentives, which were included within inflation in excess of pricing and productivity, as well as the impacts of the divestitures discussed above, foreign currency exchange rate movements and a year-over-year decrease in restructuring expenses. The year-over-year decrease in restructuring expenses impacting Costs of goods sold is due to the prior year restructuring costs related to the closure of our production facility in Turkey in 2019.
Inflation in excess of pricing and productivity includes the impact to Cost of goods sold from pricing, as defined above, in addition to productivity and inflation. Productivity represents improvements in unit costs of materials and cost reductions related to improvements to our manufacturing design and processes. Inflation includes unit costs for the current period compared to the average actual cost for the prior period, multiplied by current year volumes.
Volume/product mix represents the impact due to increases or decreases of revenue due to changes in unit volume, including new products and services, including the effect of changes in the mix of products and services sold on Cost of goods sold.
Selling and Administrative Expenses
For the year ended December 31, 2020, Selling and administrative expenses as a percentage of Net revenues decreased to 23.4% from 23.9%, due to the following:
| Productivity in excess of inflation | (2.3) | % | |||
| Volume leverage | 1.4 | % | |||
| Investment spending | 0.1 | % | |||
| Currency exchange rates | (0.1) | % | |||
| Restructuring / acquisition expenses | 0.4 | % | |||
| Total | (0.5) | % |
Selling and administrative expenses as a percentage of Net revenues for the year ended December 31, 2020, decreased primarily due to productivity benefits in excess of inflation and foreign currency exchange rate movements. These decreases were partially offset by unfavorable leverage due to lower volumes, increased investment spending and a year-over-year increase in restructuring and acquisition expenses.
Productivity in excess of inflation includes the impact from reductions in selling and administrative expenses due to productivity projects and current period costs of ongoing selling and administrative functions compared to the same ongoing expenses in the prior period. Productivity in excess of inflation also reflects the benefits of certain non-U.S. government incentives, reductions in variable compensation and reductions or delays of other business spending in the current year, in response to the COVID-19 pandemic.
Volume leverage represents the contribution margin related to changes in sales volume, excluding the impact of price, productivity, mix and inflation. Expenses related to increased head count for strategic initiatives, new facilities or significant improvements for strategic initiatives and new product development, are captured in Investment spending in the table above.
Operating Income/Margin
Operating income for the year ended December 31, 2020, decreased $161.6 million from the same period in 2019, and Operating margin decreased to 14.8% from 19.8%, due to the following:
| In millions | Operating Income | Operating Margin | |||||||||
| December 31, 2019 | $ | 565.1 | 19.8 | % | |||||||
| Pricing and productivity in excess of inflation | 66.7 | 2.1 | % | ||||||||
| Volume / product mix | (94.9) | (2.3) | % | ||||||||
| Currency exchange rates | 8.6 | 0.2 | % | ||||||||
| Investment spending | (2.1) | (0.1) | % | ||||||||
| Divestitures | 0.6 | 0.1 | % | ||||||||
| Restructuring / acquisition expenses | (6.8) | (0.3) | % | ||||||||
| Impairment of goodwill and intangible assets | (95.8) | (3.4) | % | ||||||||
| Loss on assets held for sale | (37.9) | (1.3) | % | ||||||||
| December 31, 2020 | $ | 403.5 | 14.8 | % |
The decreases in Operating income and Operating margin were largely driven by our current year goodwill and intangible asset impairment charges and loss on assets held for sale related to our QMI business. As a result of the global economic disruption and uncertainty due to the COVID-19 pandemic, we determined a triggering event had occurred as of March 31, 2020, and performed interim impairment testing on the goodwill balances of our EMEA and Asia Pacific reporting units, as well as on certain indefinite-lived trade name assets in these two regions, which resulted in impairment charges totaling $96.3 million. Additional intangible asset impairments of $2.6 million and $2.8 million were recorded in our Asia Pacific segment in the third and fourth quarters of 2020, respectively. Further, as we concluded that the net assets of our QMI business met the criteria to be classified as held for sale as of December 31, 2020, they were written down to fair value, estimated based on expected sales proceeds, less cost to sell, which resulted in a loss of $37.9 million.
The decreases in Operating income and Operating margin were also attributable to unfavorable volume/product mix, a year-over-year increase in restructuring and acquisition expenses and increased investment spending. These decreases were partially offset by pricing improvements and productivity in excess of inflation, foreign currency exchange rate movements and the impact of the divestitures discussed above.
Interest Expense
Interest expense for the year ended December 31, 2020, decreased $4.9 million compared to 2019, which is due to a lower weighted-average interest rate during the current year on our outstanding indebtedness and a $2.7 million prior year charge for the write-off of previously deferred financing costs related to the Term Facility, which did not recur in the current period.
Loss on Divestitures
In 2019, we closed our production facility in Turkey and subsequently sold certain of the production assets thereof, which represented a business, for total proceeds of approximately $4.1 million. We recorded a loss on divestiture of $24.2 million ($25.5 million, net of tax), primarily driven by the reclassification of $25.0 million of accumulated foreign currency translation adjustments to earnings upon sale. We also sold our interests in our Colombia operations in 2019 for a nominal amount, recording a net loss on divestiture of $5.9 million, of which $1.2 million related to the reclassification of accumulated foreign currency translation adjustments to earnings upon sale.
Other (Income) Expense, net
The components of Other (income) expense, net, for the years ended December 31 were as follows:
| In millions | 2020 | 2019 | ||||||||||||||||||
| Interest income | $ | (0.9) | $ | (1.8) | ||||||||||||||||
| Foreign currency exchange loss | 0.7 | 1.8 | ||||||||||||||||||
| (Earnings) loss from equity method investments | (0.3) | 0.1 | ||||||||||||||||||
| Net periodic pension and postretirement benefit (income) cost, less service cost | (2.2) | 6.8 | ||||||||||||||||||
| Other | (10.3) | (3.1) | ||||||||||||||||||
| Other (income) expense, net | $ | (13.0) | $ | 3.8 |
For the year ended December 31, 2020, Other (income) expense, net was favorable $16.8 million compared to 2019, primarily due to gains of $12.8 million related to the reclassification to earnings of accumulated foreign currency translation adjustments upon the liquidation of two legal entities in our EMEA region, which are included within Other in the table above, as well as favorable net periodic pension and postretirement benefit (income) cost, less service cost in 2020 compared to 2019.
Provision for Income Taxes
For the year ended December 31, 2020, our effective tax rate was 13.9%, compared to 15.4% for the year ended December 31, 2019. The decrease in the effective tax rate was primarily due to the favorable mix of income earned in lower tax rate jurisdictions, partially offset by the unfavorable tax impact related to goodwill and intangible asset impairment charges and the unfavorable year-over-year change in the amounts recognized for valuation allowances.
Review of Business Segments
We operate in and report financial results for three segments: Americas, EMEA and Asia Pacific. Beginning in the second quarter of 2020, results for the Company's India operations have been included within the Asia Pacific segment results, due to an operational change. This change did not result in a material impact to Segment results of operations for either the EMEA or Asia Pacific segment. These segments represent the level at which our chief operating decision maker reviews company financial performance and makes operating decisions.
Segment operating income (loss) is the measure of profit and loss that our chief operating decision maker uses to evaluate the financial performance of the business and as the basis for resource allocation, performance reviews and compensation. For these reasons, we believe that Segment operating income (loss) represents the most relevant measure of Segment profit and loss. Our chief operating decision maker may exclude certain charges or gains, such as corporate charges and other special charges, to arrive at a Segment operating income (loss) that is a more meaningful measure of profit and loss upon which to base our operating decisions. We define Segment operating margin as Segment operating income (loss) as a percentage of the segment's Net revenues.
The segment discussions that follow describe the significant factors contributing to the changes in results for each segment included in Net earnings.
Segment Results of Operations - For the years ended December 31
| In millions | 2020 | 2019 | % Change | ||||||||||||||||||||||||||||||||
| Net revenues | |||||||||||||||||||||||||||||||||||
| Americas | $ | 2,016.7 | $ | 2,114.5 | (4.6) | % | |||||||||||||||||||||||||||||
| EMEA | 554.6 | 572.5 | (3.1) | % | |||||||||||||||||||||||||||||||
| Asia Pacific | 148.6 | 167.0 | (11.0) | % | |||||||||||||||||||||||||||||||
| Total | $ | 2,719.9 | $ | 2,854.0 | |||||||||||||||||||||||||||||||
| Segment operating income (loss) | |||||||||||||||||||||||||||||||||||
| Americas | $ | 580.2 | $ | 611.6 | (5.1) | % | |||||||||||||||||||||||||||||
| EMEA | (5.4) | 34.3 | (115.7) | % | |||||||||||||||||||||||||||||||
| Asia Pacific | (96.7) | 0.5 | N/M | ||||||||||||||||||||||||||||||||
| Total | $ | 478.1 | $ | 646.4 | |||||||||||||||||||||||||||||||
| Segment operating margin | |||||||||||||||||||||||||||||||||||
| Americas | 28.8 | % | 28.9 | % | |||||||||||||||||||||||||||||||
| EMEA | (1.0) | % | 6.0 | % | |||||||||||||||||||||||||||||||
| Asia Pacific | (65.1) | % | 0.3 | % |
"N/M" = not meaningful
Americas
Our Americas segment is a leading provider of security products and solutions in approximately 30 countries throughout North America, Central America, the Caribbean and South America. The segment sells a broad range of products and solutions including, locks, locksets, portable locks, key systems, door closers, exit devices, doors and door systems, electronic products and access control systems to end-users in commercial, institutional and residential facilities, including the education, healthcare, government, hospitality, commercial office and single and multi-family residential markets. This segment’s primary brands are LCN, Schlage, Steelcraft, Technical Glass Products ("TGP") and Von Duprin.
Net revenues
Net revenues for the year ended December 31, 2020, decreased by 4.6%, or $97.8 million, compared to the same period in 2019, due to the following:
| Pricing | 1.1 | % | |||
| Volume | (5.3) | % | |||
| Divestitures | (0.4) | % | |||
| Total | (4.6) | % |
The decrease in Net revenues was principally driven by lower volumes due to the economic challenges stemming from the ongoing COVID-19 pandemic, as well as the impact of the divestiture of our Colombia business in 2019. These decreases were partially offset by improved pricing. Net revenues from residential products for the year ended December 31, 2020, increased mid-single digits compared to the same period in the prior year, primarily driven by higher volumes. Net revenues from non-residential products for the year ended December 31, 2020, decreased high single digits compared to the prior year, primarily driven by lower volumes. As a result of the COVID-19 pandemic, there have been changes in commercial real estate occupancy, constraints on government and institutional budgets and an overall uncertain business climate, which have led to declines and delays in new construction activity and discretionary projects in the non-residential construction markets we serve. These challenges are expected to continue in 2021, but the long-term impacts of the pandemic and related market disruption are not yet known.
Additionally, as end-users have continued to adopt newer technologies in their facilities and homes, accelerated by the increasing adoption of the Internet of Things ("IoT"), growth in electronic security products and solutions has become an increased metric monitored by management and of focus to our investors. For the year ended December 31, 2020, Net revenues from the sale of electronic products in the Americas segment decreased mid-single digits compared to the same period in the prior year, primarily driven by lower volumes due to delays in discretionary projects. Electronic products include all electrified product categories including, but not limited to, electronic locks, access controls and electrified exit devices.
Operating income/margin
Segment operating income for the year ended December 31, 2020, decreased $31.4 million, and Segment operating margin decreased to 28.8% from 28.9% compared to the same period in 2019, due to the following:
| In millions | Operating Income | Operating Margin | |||||||||
| December 31, 2019 | $ | 611.6 | 28.9 | % | |||||||
| Pricing and productivity in excess of inflation | 31.0 | 1.1 | % | ||||||||
| Volume / product mix | (64.8) | (1.5) | % | ||||||||
| Currency exchange rates | 5.9 | 0.3 | % | ||||||||
| Investment spending | (2.0) | (0.1) | % | ||||||||
| Divestitures | 0.7 | 0.2 | % | ||||||||
| Restructuring / acquisition expenses | (2.2) | (0.1) | % | ||||||||
| December 31, 2020 | $ | 580.2 | 28.8 | % |
The decreases in Segment operating income and Segment operating margin were primarily due to unfavorable volume/product mix, as well as increased investment spending and year-over-year increases in restructuring and acquisition expenses. These decreases were partially offset by pricing improvements and productivity in excess of inflation, foreign currency exchange rate movements and the impact of the divestiture of our Colombia business in 2019. As a result of the ongoing COVID-19 pandemic, certain of our facilities in the Americas experienced productivity challenges due to temporary closures and lower volume and demand, particularly during the second quarter; however, these productivity decreases were more than offset by reductions in variable compensation and reductions or delays of other business spending.
EMEA
Our EMEA segment provides security products, services and solutions in approximately 80 countries throughout Europe, the Middle East and Africa. The segment offers end-users a broad range of products, services and solutions including, locks, locksets, portable locks, key systems, door closers, exit devices, doors and door systems, electronic products and access control systems, as well as time and attendance and workforce productivity solutions. This segment’s primary brands are AXA, Bricard, Briton, CISA, Interflex and SimonsVoss. This segment also resells LCN, Schlage and Von Duprin products, primarily in the Middle East.
Net revenues
Net revenues for the year ended December 31, 2020, decreased by 3.1%, or $17.9 million, compared to the same period in 2019, due to the following:
| Pricing | 0.9 | % | |||
| Volume | (6.0) | % | |||
| Divestitures | (0.2) | % | |||
| Currency exchange rates | 2.2 | % | |||
| Total | (3.1) | % |
The decrease in Net revenues was principally driven by lower volumes due to the economic challenges stemming from the ongoing COVID-19 pandemic, particularly during the second quarter, as well as the divestiture of our Turkey business in 2019. These decreases were partially offset by improved pricing and favorable foreign currency exchange rate movements.
Operating income (loss)/margin
Segment operating income (loss) for the year ended December 31, 2020, was unfavorable $39.7 million, and Segment operating margin decreased to (1.0)% from 6.0% compared to the same period in 2019, due to the following:
| In millions | Operating Income (Loss) | Operating Margin | |||||||||
| December 31, 2019 | $ | 34.3 | 6.0 | % | |||||||
| Pricing and productivity in excess of inflation | 15.0 | 2.6 | % | ||||||||
| Volume / product mix | (22.4) | (3.8) | % | ||||||||
| Currency exchange rates | 2.8 | 0.4 | % | ||||||||
| Investment spending | (0.3) | (0.1) | % | ||||||||
| Divestitures | (0.1) | — | % | ||||||||
| Restructuring / acquisition expenses | 3.1 | 0.5 | % | ||||||||
| Impairment of intangible assets | 0.1 | — | % | ||||||||
| Loss on assets held for sale | (37.9) | (6.6) | % | ||||||||
| December 31, 2020 | $ | (5.4) | (1.0) | % |
Segment operating income (loss) was unfavorable primarily due to the loss on assets held for sale related to our QMI business, unfavorable volume/product mix and, to a lesser extent, increased investment spending and the impact of the divestiture of our Turkey business in 2019. These decreases were partially offset by pricing improvements and productivity in excess of inflation, foreign currency exchange rate movements, year-over-year decreases in restructuring and acquisition expenses and intangible asset impairment charges. Certain of our facilities in EMEA did experience productivity challenges as a result of the COVID-19 pandemic due to temporary closures and lower volume and demand, particularly during the second quarter in Italy; however, this was more than offset by the benefits of certain government incentives and reductions in variable compensation and other business spending. Pricing and productivity in excess of inflation also includes the impact of a $5.1 million environmental remediation charge incurred during the fourth quarter of 2020.
Segment operating margin decreased primarily due to the loss on assets held for sale, unfavorable volume/product mix and increased investment spending. These decreases were partially offset by pricing improvements and productivity in excess of inflation, foreign currency exchange rate movements and year-over-year decreases in restructuring and acquisition expenses.
Asia Pacific
Our Asia Pacific segment provides security products, services and solutions in approximately 15 countries throughout the Asia Pacific region. The segment offers end-users a broad range of products, services and solutions including, locks, locksets, portable locks, key systems, door closers, exit devices, electronic products and access control systems. This segment’s primary brands are Brio, Briton, FSH, Gainsborough, Legge, Milre and Schlage.
Net revenues
Net revenues for the year ended December 31, 2020, decreased by 11.0%, or $18.4 million, compared to the same period in 2019, due to the following:
| Pricing | (0.7) | % | |||
| Volume | (9.9) | % | |||
| Currency exchange rates | (0.4) | % | |||
| Total | (11.0) | % |
The decrease in Net revenues was principally driven by lower volumes in our Korea business, declines attributable to the economic challenges stemming from the ongoing COVID-19 pandemic and weakness in end markets throughout the region. Unfavorable foreign currency exchange rate movements and lower pricing also contributed to the decrease in Net revenues during the current year.
Operating income (loss)/margin
Segment operating income (loss) for the year ended December 31, 2020, was unfavorable $97.2 million, and Segment operating margin decreased to (65.1)% from 0.3% compared to the same period in 2019, due to the following:
| In millions | Operating Income (Loss) | Operating Margin | |||||||||
| December 31, 2019 | $ | 0.5 | 0.3 | % | |||||||
| Pricing and productivity in excess of inflation | 8.2 | 4.9 | % | ||||||||
| Volume / product mix | (7.7) | (4.9) | % | ||||||||
| Currency exchange rates | (0.1) | (0.1) | % | ||||||||
| Investment spending | 0.8 | 0.5 | % | ||||||||
| Restructuring / acquisition expenses | (2.5) | (1.5) | % | ||||||||
| Impairment of goodwill and intangible assets | (95.9) | (64.3) | % | ||||||||
| December 31, 2020 | $ | (96.7) | (65.1) | % |
The decreases to Segment operating income (loss) and Segment operating margin were both primarily due to an $88.1 million goodwill impairment charge in the first quarter of 2020 and increased year-over-year intangible asset impairment charges, as well as unfavorable volume/product mix, year-over-year increases in restructuring and acquisition expenses and foreign currency exchange rate movements. These decreases were partially offset by productivity improvements in excess of lower pricing and inflation and decreased investment spending. Pricing and productivity in excess of inflation includes the impact of a $4.0 million gain on the sale of a building within the region during the fourth quarter of 2020.
Liquidity and Capital Resources
Sources and uses of liquidity
Our primary source of liquidity is cash provided by operating activities. Cash provided by operating activities is used to invest in new product development and fund capital expenditures and working capital requirements and is expected to be adequate to service any future debt, pay any declared dividends and potentially fund acquisitions and share repurchases. Our ability to fund these capital needs depends on our ongoing ability to generate cash from our operating activities and to access our borrowing facilities (including unused availability under our Revolving Facility) and capital markets.
Throughout 2020, we have closely monitored the developments related to the COVID-19 pandemic, including the resulting uncertainties around customer demand, supply chain disruption, the availability and cost of materials, customer and supplier financial condition, levels of liquidity and our ongoing compliance with debt covenants. While our business and results of
operations have been negatively impacted by the pandemic and the resulting global economic slowdown, we have no required principal payments on our long-term debt until September 2022, maintain cash and cash equivalents of $480.4 million and have unused availability of $485.0 million under our Revolving Facility as of December 31, 2020. Further, our business operates with low capital intensity, providing financial flexibility during this time of continued uncertainty. We believe that our actions taken to date, future cash provided by operating activities, availability under our Revolving Facility, access to funds on hand and capital markets, as well as other potential measures within our control to maintain a sound financial position and liquidity, will provide adequate resources to fund our operating and financing needs.
The following table reflects the major categories of cash flows for the years ended December 31. For additional details, please see the Consolidated Statements of Cash Flows in the Consolidated Financial Statements.
| In millions | 2020 | 2019 | ||||||||||||||||||
| Net cash provided by operating activities | $ | 490.3 | $ | 488.2 | ||||||||||||||||
| Net cash used in investing activities | (56.7) | (77.6) | ||||||||||||||||||
| Net cash used in financing activities | $ | (321.9) | $ | (342.2) |
Operating activities
Net cash provided by operating activities for the year ended December 31, 2020, increased $2.1 million compared to 2019. As discussed above, Net cash provided by operating activities for the year ended December 31, 2020, included benefits totaling approximately $30 million due to measures included in the CARES Act.
Investing activities
Net cash used in investing activities for the year ended December 31, 2020, decreased $20.9 million compared to 2019, primarily due to a decrease in capital expenditures.
Financing activities
Net cash used in financing activities for the year ended December 31, 2020, decreased $20.3 million compared to 2019. The year over-year reductions in debt repayments and cash used to repurchase shares of $17.7 million and $17.2 million, respectively, were partially offset by a year-over-year increase in dividend payments to ordinary shareholders of $16.7 million.
Capitalization
At December 31, long-term debt and other borrowings consisted of the following:
| In millions | 2020 | 2019 | |||||||||
| Term Facility | $ | 238.8 | $ | 238.8 | |||||||
| Revolving Facility | — | — | |||||||||
| 3.200% Senior Notes due 2024 | 400.0 | 400.0 | |||||||||
| 3.550% Senior Notes due 2027 | 400.0 | 400.0 | |||||||||
| 3.500% Senior Notes due 2029 | 400.0 | 400.0 | |||||||||
| Other debt | 0.6 | 0.7 | |||||||||
| Total borrowings outstanding | 1,439.4 | 1,439.5 | |||||||||
| Less discounts and debt issuance costs, net | (9.8) | (11.8) | |||||||||
| Total debt | 1,429.6 | 1,427.7 | |||||||||
| Less current portion of long-term debt | 0.2 | 0.1 | |||||||||
| Total long-term debt | $ | 1,429.4 | $ | 1,427.6 |
As of December 31, 2020, we have an unsecured Credit Agreement in place, consisting of a $700.0 million term loan facility (the “Term Facility”), of which $238.8 million is outstanding, and a $500.0 million revolving credit facility (the “Revolving Facility” and, together with the Term Facility, the “Credit Facilities”). The Credit Facilities mature on September 12, 2022.
At inception, the Term Facility was scheduled to amortize in quarterly installments at the following rates: 1.25% per quarter starting December 31, 2017 through December 31, 2020, 2.5% per quarter from March 31, 2021 through June 30, 2022, with the balance due on September 12, 2022. Principal amounts repaid on the Term Facility may not be reborrowed. During the third
quarter of 2019, we made a $400.0 million principal payment to partially pay down the outstanding Term Facility balance. As a result of this payment, we have satisfied our obligation to make quarterly installments on the Term Facility up to the maturity date, with the remaining outstanding balance due on September 12, 2022.
The Revolving Facility provides aggregate commitments of up to $500.0 million, which includes up to $100.0 million for the issuance of letters of credit. At December 31, 2020, there were no borrowings outstanding on the Revolving Facility, and we had $15.0 million of letters of credit outstanding. Commitments under the Revolving Facility may be reduced at any time without premium or penalty, and amounts repaid may be reborrowed.
Outstanding borrowings under the Credit Facilities accrue interest at our option of (i) a LIBOR rate plus the applicable margin or (ii) a base rate plus the applicable margin. The applicable margin ranges from 1.125% to 1.500% depending on our credit ratings. At December 31, 2020, outstanding borrowings under the Credit Facilities accrue interest at LIBOR plus a margin of 1.250%, resulting in an interest rate of 1.51%.
As of December 31, 2020, we also have $400.0 million outstanding of 3.200% Senior Notes due 2024 (the "3.200% Senior Notes"), $400.0 million outstanding of 3.550% Senior Notes due 2027 (the "3.550% Senior Notes") and $400.0 million outstanding of 3.500% Senior Notes due 2029 (the "3.500% Senior Notes", and all three senior notes collectively, the "Senior Notes"). The Senior Notes require semi-annual interest payments on April 1 and October 1 of each year, and will mature on October 1, 2024, October 1, 2027, and October 1, 2029, respectively.
Historically, the majority of our earnings were considered to be permanently reinvested in jurisdictions where we have made, and intend to continue to make, substantial investments to support the ongoing development and growth of our global operations. At December 31, 2020, we have analyzed our working capital requirements and the potential tax liabilities that would be incurred if certain subsidiaries made distributions and concluded that no material changes to our historic permanent reinvestment assertions are required.
Defined Benefit Plans
Our investment objective in managing defined benefit plan assets is to ensure that all present and future benefit obligations are met as they come due. We seek to achieve this goal while trying to mitigate volatility in plan funded status, contributions and expense by better matching the characteristics of the plan assets to that of the plan liabilities. Global asset allocation decisions are based on a dynamic approach whereby a plan's allocation to fixed income assets increases as the funded status increases. We monitor plan funded status, asset allocation and the impact of market conditions on our defined benefit plans regularly in addition to investment manager performance. None of our defined benefit pension plans have experienced a significant impact on their liquidity due to volatility in the markets. For further details on pension plan activity, see Note 12 to the Consolidated Financial Statements.
Contractual Obligations
The following table summarizes our contractual cash obligations by required payment periods:
| In millions | 2021 | 2022-2023 | 2024-2025 | Thereafter | Total | |||||||||||||||||||||||||||
| Long-term debt (including current maturities) | $ | 0.2 | $ | 239.1 | $ | 400.1 | $ | 800.0 | $ | 1,439.4 | ||||||||||||||||||||||
| Interest payments on long-term debt | 45.6 | 85.4 | 66.0 | 77.3 | 274.3 | |||||||||||||||||||||||||||
| Purchase obligations | 462.5 | — | — | — | 462.5 | |||||||||||||||||||||||||||
| Operating leases | 30.4 | 38.2 | 16.8 | 19.5 | 104.9 | |||||||||||||||||||||||||||
| Total contractual cash obligations | $ | 538.7 | $ | 362.7 | $ | 482.9 | $ | 896.8 | $ | 2,281.1 |
Future interest payments on variable rate long-term debt are estimated based on the rate in effect as of December 31, 2020. As the timing and amounts of our future expected obligations under our defined benefit plans, income taxes, environmental and product liability matters are uncertain, they have not been included in the contractual cash obligations table above, but rather, are discussed below:
Defined Benefit Pension and Postretirement ("OPEB") Plans
At December 31, 2020, we had net pension liabilities of $20.2 million, which consist of plan assets of $796.9 million and benefit obligations of $817.1 million. It is our objective to contribute to our pension plans in order to ensure adequate funds are available in the plans to make benefit payments to plan participants and beneficiaries when required. At December 31, 2020, the funded status of our qualified pension plan for U.S. employees increased to 98.7% from 93.5% at December 31, 2019. The
funded status for our non-U.S. pension plans increased to 101.8% at December 31, 2020 from 101.1% at December 31, 2019. The funded status for all of our pension plans at December 31, 2020 increased to 97.5% from 95.3% at December 31, 2019. We currently project that approximately $11.4 million will be contributed to our plans worldwide in 2021.
At December 31, 2020, we also had OPEB obligations of $5.2 million. We fund OPEB costs principally on a pay-as-you-go basis as medical costs are incurred by covered retiree populations. Benefit payments, which are net of expected plan participant contributions and Medicare Part D subsidies, are not expected to be material in 2021. See Note 12 to the Consolidated Financial Statements for additional information related to our pension and OPEB obligations.
Income Taxes
At December 31, 2020, we have total unrecognized tax benefits for uncertain tax positions of $41.2 million and $7.6 million of related accrued interest and penalties, net of tax. These liabilities have been excluded from the preceding table as we are unable to reasonably estimate the amount and period in which these liabilities might be paid. See Note 18 to the Consolidated Financial Statements for additional information regarding matters relating to income taxes, including unrecognized tax benefits and tax authority disputes.
Contingent Liabilities
We are involved in various litigation, claims and administrative proceedings, including those related to environmental, asbestos-related and product liability matters. We believe that these liabilities are subject to the uncertainties inherent in estimating future costs for contingent liabilities and will likely be resolved over an extended period of time. See Note 21 to the Consolidated Financial Statements for additional information.
Guarantor Financial Information
In March 2020, the SEC adopted amendments to the financial disclosure requirements applicable to registered debt offerings that include credit enhancements, such as subsidiary guarantees, in Rule 3-10 of Regulation S-X. The amended rules focus on providing material, relevant and decision-useful information regarding guarantees and other credit enhancements, while eliminating certain prescriptive requirements. We adopted these amendments on March 31, 2020. Accordingly, summarized financial information has been presented only for the issuers and guarantors of our registered securities for the most recent fiscal year, and the location of the required disclosures has been moved outside the Notes to the Consolidated Financial Statements and is provided below.
Allegion US Holding Company Inc. ("Allegion US Hold Co") is the issuer of the 3.200% Senior Notes and 3.550% Senior Notes and is the guarantor of the 3.500% Senior Notes. Allegion plc (the “Parent”) is the issuer of the 3.500% Senior Notes and is the guarantor of the 3.200% Senior Notes and 3.550% Senior Notes. Allegion US Hold Co is 100% owned by the Parent and each of the guarantees of Allegion US Hold Co and the Parent is full and unconditional and joint and several.
The 3.200% Senior Notes and the 3.550% Senior Notes are senior unsecured obligations of Allegion US Hold Co and rank equally with all of Allegion US Hold Co’s existing and future senior unsecured and unsubordinated indebtedness. The guarantee of the 3.200% Senior Notes and the 3.550% Senior Notes is the senior unsecured obligation of the Parent and ranks equally with all of Allegion plc’s existing and future senior unsecured and unsubordinated indebtedness. The 3.500% Senior Notes are senior unsecured obligations of the Parent, are guaranteed by Allegion US Hold Co and rank equally with all of Allegion plc’s existing and future senior unsecured indebtedness.
Each guarantee is effectively subordinated to any secured indebtedness of the Guarantor to the extent of the value of the assets securing such indebtedness. The Senior Notes are structurally subordinated to indebtedness and other liabilities of the subsidiaries of the Guarantor, none of which guarantee the notes. The obligations of the Guarantor under its Guarantee are limited as necessary to prevent such Guarantee from constituting a fraudulent conveyance under applicable law and, therefore, are limited to the amount that the Guarantor could guarantee without such Guarantee constituting a fraudulent conveyance; this limitation, however, may not be effective to prevent such Guarantee from constituting a fraudulent conveyance. If the Guarantee was rendered voidable, it could be subordinated by a court to all other indebtedness (including guarantees and other contingent liabilities) of the Guarantor, and, depending on the amount of such indebtedness, the Guarantor’s liability on its Guarantee could be reduced to zero. In such an event, the notes would be structurally subordinated to the indebtedness and other liabilities of the Guarantor.
For further details, terms and conditions of the Senior Notes refer to the Company’s Form 8-K filed October 2, 2017 and Form 8-K filed September 27, 2019.
The following tables present the summarized financial information specified in Rule 1-02(bb)(1) of Regulation S-X for each issuer and guarantor. The summarized financial information has been prepared in accordance with Rule 13-01 of Regulation S-X.
Selected Condensed Statement of Comprehensive Income Information
| Year ended December 31, 2020 | |||||||||||||||||||||||
| In millions | Allegion plc | Allegion US Hold Co | |||||||||||||||||||||
| Net revenues | $ | — | $ | — | |||||||||||||||||||
| Gross profit | — | — | |||||||||||||||||||||
| Operating loss | (7.5) | (0.2) | |||||||||||||||||||||
| Equity earnings in affiliates, net of tax | 358.8 | 216.5 | |||||||||||||||||||||
| Transactions with related parties and subsidiaries(a) | (15.3) | (39.3) | |||||||||||||||||||||
| Net earnings | 314.3 | 164.7 | |||||||||||||||||||||
| Net earnings attributable to the entity | 314.3 | 164.7 |
(a) Transactions with related parties and subsidiaries include intercompany interest and fees.
Selected Condensed Balance Sheet Information
| December 31, 2020 | |||||||||||||||||||||||
| In millions | Allegion plc | Allegion US Hold Co | |||||||||||||||||||||
| Current assets: | |||||||||||||||||||||||
| Amounts due from related parties and subsidiaries | $ | — | $ | 20.0 | |||||||||||||||||||
| Total current assets | 19.0 | 38.7 | |||||||||||||||||||||
| Noncurrent assets: | |||||||||||||||||||||||
| Amounts due from related parties and subsidiaries | — | 1,644.2 | |||||||||||||||||||||
| Total noncurrent assets | 1,793.3 | 1,671.8 | |||||||||||||||||||||
| Current liabilities: | |||||||||||||||||||||||
| Amounts due to related parties and subsidiaries | $ | 197.5 | $ | 183.9 | |||||||||||||||||||
| Total current liabilities | 204.4 | 190.7 | |||||||||||||||||||||
| Noncurrent liabilities: | |||||||||||||||||||||||
| Amounts due to related parties and subsidiaries | 507.3 | 2,463.9 | |||||||||||||||||||||
| Total noncurrent liabilities | 1,143.2 | 3,267.3 |
Critical Accounting Policies
Management’s Discussion and Analysis of Financial Condition and Results of Operations are based upon our Consolidated Financial Statements, which have been prepared in accordance with GAAP. The preparation of financial statements in conformity with those accounting principles requires management to use judgment in making estimates and assumptions based on the relevant information available at the end of each period. These estimates and assumptions have a significant effect on reported amounts of assets and liabilities, revenues and expenses as well as the disclosure of contingent assets and liabilities because they result primarily from the need to make estimates and assumptions on matters that are inherently uncertain. Actual results may differ from estimates. If updated information or actual amounts are different from previous estimates, the revisions are included in our results for the period in which they become known.
The following is a summary of certain accounting estimates and assumptions made by management that we consider critical:
- Goodwill – Goodwill is tested annually during the fourth quarter for impairment or when there is a significant change in events or circumstances that indicate the fair value of a reporting unit is more likely than not less than its carrying amount. Recoverability of goodwill is measured at the reporting unit level and starts with a comparison of the carrying amount of a reporting unit to its estimated fair value. If the estimated fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is not impaired. To the extent that the carrying value of a reporting unit exceeds its estimated fair value, a goodwill impairment charge will be recognized for the amount by which the carrying value of the reporting unit exceeds its fair value, not to exceed the carrying amount of the reporting unit's goodwill.
As quoted market prices are not available for our reporting units, the calculation of their estimated fair values is based on two valuation techniques, a discounted cash flow model (income approach) and a market multiple of earnings (market approach), with each method being weighted in the calculation. The income approach relies on the Company’s estimates of revenue growth rates, terminal growth rates, margin assumptions and discount rates to estimate future cash flows and explicitly addresses factors such as timing, with due consideration given to forecasting risk. The market approach requires determining an appropriate peer group, which is utilized to derive estimated fair values of our reporting units based on selected market multiples. The market approach reflects the market’s expectations for future growth and risk, with adjustments to account for differences between the selected peer group companies and the subject reporting units.
As a result of the global economic disruption and uncertainty due to the COVID-19 pandemic, we concluded a triggering event had occurred as of March 31, 2020, and accordingly, performed interim impairment testing on the goodwill balances of our EMEA and Asia Pacific reporting units. Given the high degree of market volatility and lack of reliable market data that existed as of March 31, 2020, we determined a discounted cash flow model (income approach) provided the best approximation of fair value of the EMEA and Asia Pacific reporting units for the purpose of performing these interim tests. This was a change in estimate, as historically our determination of reporting unit fair values has been estimated based on both an income and a market approach, as discussed above, with each method being weighted in the calculation. The results of the interim impairment testing indicated the estimated fair value of the Asia Pacific reporting unit was less than its carrying value, and consequently, a goodwill impairment charge of $88.1 million was recorded.
As markets stabilized throughout the year, we reverted to utilizing both an income and market approach while performing our annual impairment test in the fourth quarter. The estimated fair values for each of our reporting units exceeded their carrying values by more than 20% for the annual 2020 goodwill impairment test, completed in the fourth quarter. Assessing the fair value of our reporting units includes, among other things, making key assumptions for estimating future cash flows and appropriate market multiples. These assumptions are subject to a high degree of judgment and complexity. We make every effort to estimate future cash flows as accurately as possible with the information available at the time the forecast is developed. However, changes in assumptions and estimates may affect the estimated fair value of the reporting unit and could result in impairment charges in future periods. Factors that have the potential to create variances in the estimated fair value of the reporting unit include, but are not limited to, the following:
-
Decreases in estimated market sizes or market growth rates due to greater-than-expected declines in volumes, pricing pressures or disruptive technology;
-
Declines in our market share and penetration assumptions due to increased competition or an inability to develop or launch new products;
-
The impacts of market volatility, including greater-than-expected declines in pricing, reductions in volumes or fluctuations in foreign exchange rates;
-
The level of success of on-going and future research and development efforts, including those related to acquisitions, and increases in the research and development costs necessary to obtain regulatory approvals and launch new products;
-
Increases in the price or decreases in the availability of key commodities and the impact of higher energy prices; and
-
Increases in our market-participant risk-adjusted weighted-average cost of capital.
*•*Indefinite-lived intangible assets – Similar to goodwill, indefinite-lived intangible assets are tested annually during the fourth quarter for impairment or when there is a significant change in events or circumstances that indicate the fair value of the asset is more likely than not less than its carrying amount. Recoverability of indefinite-lived intangible assets is determined on a relief from royalty methodology, which is based on the implied royalty paid, at an appropriate discount rate, to license the use of an asset rather than owning the asset. The present value of the after-tax cost savings (i.e. royalty relief) indicates the estimated fair value of the asset. Any excess of the carrying value over the estimated fair value is recognized as an impairment loss equal to that excess. During the first quarter of 2020, we concluded the global economic disruption and uncertainty due to the COVID-19 pandemic to be a triggering event. Accordingly, interim impairment tests on certain indefinite-lived trade names were performed as of March 31, 2020. Based on these tests, it was determined that three of our indefinite-lived trade names in the EMEA and Asia Pacific segments were impaired, and impairment charges totaling $8.2 million were recorded.
A significant increase in the discount rate, decrease in the terminal growth rate, decrease in the royalty rate or substantial reductions in future revenue projections could have a negative impact on the estimated fair values of any of our indefinite-lived intangible assets.
- Income taxes – We account for income taxes in accordance with ASC Topic 740. Deferred tax assets and liabilities are determined based on temporary differences between financial reporting and tax bases of assets and liabilities, applying enacted tax rates expected to be in effect for the year in which the differences are expected to reverse. We recognize future tax benefits, such as net operating losses and non-U.S. tax credits, to the extent that realizing these benefits is considered in our judgment to be more likely than not. We regularly review the recoverability of our deferred tax assets considering our historic profitability, projected future taxable income, timing of the reversals of existing temporary differences and the feasibility of our tax planning strategies. Where appropriate, we record a valuation allowance with respect to future tax benefits.
The provision for income taxes involves a significant amount of management judgment regarding interpretation of relevant facts and laws in the jurisdictions in which we operate. Future changes in applicable laws, projected levels of taxable income and tax planning could change the effective tax rate and tax balances recorded by us. In addition, tax authorities periodically review income tax returns filed by us and can raise issues regarding our filing positions, timing and amount of income or deductions and the allocation of income among the jurisdictions in which we operate. A significant period of time may elapse between the filing of an income tax return and the ultimate resolution of an issue raised by a revenue authority with respect to that return. We believe that we have adequately provided for any reasonably foreseeable resolution of these matters. We will adjust our estimates if significant events so dictate. To the extent that the ultimate results differ from our original or adjusted estimates, the effect will be recorded in the provision for income taxes in the period that the matter is finally resolved.
- Defined benefit plans – We provide several U.S. and non-U.S. defined benefit pension plan benefits to eligible employees and retirees. Our noncontributory defined benefit pension plans covering non-collectively bargained U.S. employees provide benefits on an average pay formula while most plans for collectively bargained U.S. employees provide benefits on a flat dollar benefit formula. The non-U.S. pension plans generally provide benefits based on earnings and years of service. Determining the costs associated with such plans is dependent on various actuarial assumptions including discount rates, expected return on plan assets, employee mortality and turnover rates. Actuarial valuations are performed to determine expense in accordance with GAAP. Actual results may differ from the actuarial assumptions and are generally recorded to Accumulated other comprehensive loss and amortized into earnings over future periods.
We review our actuarial assumptions at each measurement date and make modifications to the assumptions as appropriate. The discount rate and expected return on plan assets are determined as of each measurement date. Discount rates for all plans are established using hypothetical yield curves based on the yields of corporate bonds rated AA quality. Spot rates are developed from the yield curve and used to discount future benefit payments. The expected return on plan assets reflects the average rate of returns expected on the funds invested or to be invested to provide for the benefits included in the projected benefit obligation. The expected return on plan assets is based on what is achievable given the plan’s investment policy, the types of assets held and the target asset allocation. We believe the assumptions utilized in recording our defined benefit obligations are reasonable based on input from our actuaries, outside investment advisors and information as to assumptions used by plan sponsors.
Changes in any of the assumptions can have an impact on the net periodic pension benefit cost. An estimated 0.25% rate decline in the discount rate would increase net periodic pension benefit cost by approximately $1.1 million in 2021, while a 0.25% rate decline in the estimated return on assets would increase net periodic pension benefit cost by approximately $1.9 million.
- Business combinations – The fair value of consideration paid in a business combination is allocated to the tangible and identifiable intangible assets acquired, liabilities assumed and goodwill. Acquired intangible assets primarily include indefinite-lived trade names, customer relationships and completed technologies. The accounting for business combinations involves a considerable amount of judgment and estimation, including the fair value of acquired intangible assets involving projections of future revenues and cash flows that are either discounted at an estimated discount rate or measured at an estimated royalty rate; fair value of other acquired assets and assumed liabilities, including potential contingencies; and the useful lives of the acquired assets. The assumptions used to determine the fair value of acquired intangible assets include projections developed using internal forecasts, available industry and market data, estimates of long-term growth rates, profitability, customer attrition and royalty rates, which are determined at the time of acquisition. An income approach or market approach (or both) is utilized in accordance with accepted valuation models for each acquired intangible asset to determine fair value. The impact of prior or future business combinations on our financial condition or results of operations may be materially impacted by the change in or initial selection of assumptions and estimates.
Recent Accounting Pronouncements
See Note 2 to our Consolidated Financial Statements included in Item 8 herein for a discussion of recently issued and adopted accounting pronouncements.
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