filings.toolsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
46K characters. Original on sec.gov · Markdown
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
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This report includes forward-looking statements based on the Company’s current assumptions, expectations and projections about future events. When used in this report, the words “believes,” “anticipates,” “may,” “expect,” “intend,” “estimate,” “project” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain such words. In this report, the Company discloses important factors that could cause actual results to differ materially from management’s expectations. For more information on these and other factors, see “Forward-Looking Information” herein.
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with “Item 1A. Risk Factors,” “Item 6. Selected Financial Data” and the consolidated financial statements and related notes included elsewhere in this Annual Report on Form
10-K.
Business Overview
AMETEK’s operations are affected by global, regional and industry economic factors. However, the Company’s strategic geographic and industry diversification, and its mix of products and services, have helped to mitigate the potential adverse impact of any unfavorable developments in any one industry or the economy of any single country on its consolidated operating results. In 2019, the Company posted record backlog, orders, sales, operating income, net income, diluted earnings per share and operating cash flow. The Company’s record backlog, contributions from recent acquisitions, and continued focus on and implementation of Operational Excellence initiatives, had a positive impact on 2019 results. The Company also benefited from its strategic initiatives under AMETEK’s four key strategies: Operational Excellence, Strategic Acquisitions, Global & Market Expansion and New Products.
Highlights of 2019 were:
| • | Orders for 2019 were $5,274.3 million, an increase of $222.5 million or 4.4%, compared with $5,051.8 million in 2018. As a result, the Company’s backlog of unfilled orders at December 31, 2019 was $1,717.9 million. |
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| • | Net sales for 2019 were $5,158.6 million, an increase of $312.7 million or 6.5%, compared with $4,845.9 million in 2018. The increase in net sales for 2019 was due to 2% organic sales growth, a 5% increase from the 2019 and 2018 acquisitions, partially offset by unfavorable foreign currency translation. |
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| • | Net income for 2019 was $861.3 million, an increase of $83.4 million or 10.7%, compared with $777.9 million in 2018. |
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| • | Diluted earnings per share for 2019 were $3.75, an increase of $0.41 or 12.3%, compared with $3.34 per diluted share in 2018. |
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| • | Cash flow provided by operating activities for 2019 was $1,114.4 million, an increase of $188.9 million or 20.4%, compared with $925.5 million in 2018. |
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| • | During 2019, the Company spent $1,061.9 million in cash, net of cash acquired, to acquire two businesses: |
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| • | In September 2019, AMETEK acquired Pacific Design Technologies, Inc. (“PDT”), a provider of advanced, mission-critical thermal management solutions; and |
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| • | In October 2019, AMETEK acquired Gatan, a provider of instrumentation and software used to enhance and extend the operation and performance of electron telescopes. |
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| • | In the fourth quarter of 2019, the Company paid in full, at maturity, $100 million in aggregate principal amount of 6.30% private placement senior notes. |
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| • | A $100 million second funding of the December 2018 Private Placement occurred in January 2019. |
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| • | In 2019, the Company repurchased approximately 133,000 shares of its common stock for $11.9 million. |
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| • | The Company continued its emphasis on investment in research, development and engineering, spending $260.3 million in 2019 before customer reimbursement of $3.2 million. |
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Results of Operations
The following table sets forth net sales and income by reportable segment and on a consolidated basis:
| Year Ended December 31, | ||||||||||||
| 2019 | 2018 | 2017 | ||||||||||
| (In thousands) | ||||||||||||
| Net sales: | ||||||||||||
| Electronic Instruments | $ | 3,322,881 | $ | 3,028,959 | $ | 2,690,554 | ||||||
| Electromechanical | 1,835,676 | 1,816,913 | 1,609,616 | |||||||||
| Consolidated net sales | $ | 5,158,557 | $ | 4,845,872 | $ | 4,300,170 | ||||||
| Operating income and income before income taxes: | ||||||||||||
| Segment operating income: | ||||||||||||
| Electronic Instruments | $ | 865,307 | $ | 782,144 | $ | 671,646 | ||||||
| Electromechanical | 387,931 | 363,765 | 306,779 | |||||||||
| Total segment operating income | 1,253,238 | 1,145,909 | 978,425 | |||||||||
| Corporate administrative expenses | (75,858 | ) | (70,369 | ) | (74,805 | ) | ||||||
| Consolidated operating income | 1,177,380 | 1,075,540 | 903,620 | |||||||||
| Interest expense | (88,481 | ) | (82,180 | ) | (98,029 | ) | ||||||
| Other expense, net | (19,151 | ) | (5,615 | ) | (8,862 | ) | ||||||
| Consolidated income before income taxes | $ | 1,069,748 | $ | 987,745 | $ | 796,729 | ||||||
The following “Results of Operations of the year ended December 31, 2019 compared with the year ended December 31, 2018” section presents an analysis of the Company’s consolidated operating results displayed in the Consolidated Statement of Income. A discussion regarding our financial condition and results of operations for the year ended December 31, 2018 compared to the year ended December 31, 2017 can be found under Item 7 in our Annual Report on Form
10-K
for the fiscal year ended December 31, 2018, filed with the Securities and Exchange Commission on February 21, 2019.
Results of Operations for the year ended December 31, 2019 compared with the year ended December 31, 2018
In 2019, the Company posted record sales, operating income, net income, diluted earnings per share, orders, backlog and operating cash flow. The Company achieved these results from organic sales growth in both EIG and EMG, contributions from the 2019 acquisitions of Gatan and PDT and 2018 acquisitions of Spectro Scientific, Telular, Forza, Motec and SoundCom, as well as from the Company’s Operational Excellence initiatives.
The Company’s record backlog, the full year impact of the 2019 acquisitions and continued focus on and implementation of Operational Excellence initiatives are expected to have a positive impact on the Company’s 2020 results.
Net sales for 2019 were $5,158.6 million, an increase of $312.7 million or 6.5%, compared with net sales of $4,845.9 million in 2018. The increase in net sales for 2019 was due to 2% organic sales growth, a 5% increase from acquisitions, partially offset by unfavorable foreign currency translation. EIG net sales were $3,322.9 million in 2019, an increase of 9.7%, compared with $3,029.0 million in 2018. EMG net sales were $1,835.7 million in 2019, an increase of 1.0%, compared with $1,816.9 million in 2018.
Total international sales for 2019 were $2,474.9 million or 48.0% of net sales, an increase of $26.4 million or 1.1%, compared with international sales of $2,448.5 million or 50.5% of net sales in 2018. The increase in international sales was primarily driven by recent acquisitions. Export shipments from the United States, which are included in total international sales, were $1,306.2 million in 2019, an increase of $36.8 million or 2.9%, compared with $1,269.4 million in 2018.
Orders for 2019 were $5,274.3 million, an increase of $222.5 million or 4.4%, compared with $5,051.8 million in 2018. The increase in orders for 2019 was driven by the 2018 and 2019 acquisitions. The Company’s backlog of unfilled orders at December 31, 2019 was $1,717.9 million, an increase of $115.8 million or 7.2%, compared with $1,602.1 million at December 31, 2018.
Segment operating income for 2019 was $1,253.2 million, an increase of $107.3 million or 9.4%, compared with segment operating income of $1,145.9 million in 2018. Segment operating income, as a percentage of net sales, increased to 24.3% in 2019, compared with 23.6% in 2018. The increase in segment operating income and segment operating margins for 2019 resulted primarily from the increase in net sales, as well as the benefits of the Company’s Operational Excellence initiatives.
Cost of sales for 2019 was $3,370.9 million or 65.3% of net sales, an increase of $184.6 million or 5.8%, compared with $3,186.3 million or 65.8% of net sales for 2018. Cost of sales increased primarily due to the increase in net sales noted above.
Selling, general and administrative expenses for 2019 were $610.3 million or 11.8% of net sales, an increase of $26.3 million or 4.5%, compared with $584.0 million or 12.1% of net sales in 2018. Selling, general and administrative expenses increased primarily due to the increase in net sales noted above.
Consolidated operating income was $1,177.4 million or 22.8% of net sales for 2019, an increase of $101.9 million or 9.5%, compared with $1,075.5 million or 22.2% of net sales in 2018.
Interest expense was $88.5 million for 2019, an increase of $6.3 million or 7.7%, compared with $82.2 million in 2018. The interest expense increase for 2019 was primarily driven by the 2018 private placement senior notes issued in December 2018 ($475 million and 75 million Euros) and January 2019 ($100 million), partially offset by a decrease related to the repayment in full, at maturity, of $80 million in aggregate principal amount of 6.35% private placement senior notes and $160 million in aggregate principal amount of 7.08% private placement senior notes in the third quarter of 2018, $65 million in aggregate principal amount of 7.18% private placement senior notes in the fourth quarter of 2018, and $100 million in aggregate principal amount of 6.03% private placement senior notes in the fourth quarter of 2019.
Other expense, net was $19.2 million for 2019, an increase of $13.6 million, compared with $5.6 million in 2018. The Other expense, net increase for 2019 was primarily due to lower defined benefit pension income included in Other expenses.
The effective tax rate for 2019 was 19.5%, compared with 21.2% in 2018. The lower rate for 2019 mainly reflects higher year over year tax benefits related to share-based payment transactions as well as lower tax cost on foreign source income. The 2019 and 2018 effective tax rates also reflect the release of uncertain tax position liabilities primarily relating to statute expirations for U.S. Federal and State jurisdictions totaling $23.3 million and $11.4 million, respectively. See Note 9 to the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form
10-K
for further details.
Net income for 2019 was $861.3 million, an increase of $83.4 million or 10.7%, compared with $777.9 million in 2018. Diluted earnings per share for 2019 were $3.75, an increase of $0.41 or 12.3%, compared with $3.34 per diluted share in 2018.
Segment Results
EIG’s
net
sales totaled $3,322.9 million for 2019, an increase of $293.9 million or 9.7%, compared with $3,029.0 million in 2018. The net sales increase was due to 3% organic sales growth, an 8% increase from the 2019 acquisition of Gatan and the 2018 acquisitions of Spectro Scientific, Telular, Forza, Motec and SoundCom, partially offset by an unfavorable 1% effect of foreign currency translation.
EIG’s operating income was $865.3 million for 2019, an increase of $83.2 million or 10.6%, compared with $782.1 million in 2018. EIG’s operating margins were 26.0% of net sales for 2019, compared with 25.8% of net sales in 2018. The increase in EIG’s operating income and operating margins for 2019 resulted primarily from the increase in net sales noted above, as well as the benefits of the Group’s Operational Excellence initiatives.
EMG’s
net sales totaled $1,835.7 million for 2019, an increase of $18.8 million or 1.0%, compared with $1,816.9 million in 2018. The net sales increase was due to 2% organic sales growth, a 1% increase from the 2019 acquisition of PDT and the 2018 acquisition of FMH, partially offset by unfavorable 2% foreign currency translation.
EMG’s operating income was $387.9 million for 2019, an increase of $24.1 million or 6.6%, compared with $363.8 million in 2018. EMG’s operating margins were 21.1% of net sales for 2019, compared with 20.0% of net sales in 2018. The increase in EMG’s operating income in 2019 resulted primarily from the increase in net sales noted above, as well as the benefits of the Group’s Operational Excellence initiatives.
Liquidity and Capital Resources
Cash provided by operating activities totaled $1,114.4 million in 2019, an increase of $188.9 million or 20.4%, compared with $925.5 million in 2018. The increase in cash provided by operating activities for 2019 was primarily due to higher net income of $83.4 million and lower deferred income taxes.
Free cash flow (cash flow provided by operating activities less capital expenditures) was $1,012.1 million in 2019, compared with $843.4 million in 2018. EBITDA (earnings before interest, income taxes, depreciation and amortization) was $1,388.3 million in 2019, compared with $1,267.7 million in 2018. Free cash flow and EBITDA are presented because the Company is aware that they are measures used by third parties in evaluating the Company. (See the “Notes to Selected Financial Data” included in Item 6 in this Annual Report on Form
10-K
for a reconciliation of U.S. GAAP measures to comparable
non-GAAP
measures).
Cash used for investing activities totaled $1,150.9 million in 2019, compared with $1,210.0 million in 2018. In 2019, the Company paid $1,061.9, net of cash acquired, to acquire PDT in September 2019 and Gatan in October 2019. In 2018, the Company paid $1,129.3 million, net of cash acquired, to acquire Spectro Scientific in November 2018, Telular and Forza in October 2018, Motec in June 2018, SoundCom in April 2018 and FMH in January 2018. Additions to property, plant and equipment totaled $102.3 million in 2019, compared with $82.1 million in 2018.
Cash provided by financing activities totaled $72.9 million in 2019, compared with $13.0 million of cash provided by financing activities in 2018. At December 31, 2019, total debt, net was $2,768.7 million, compared with $2,632.7 million at December 31, 2018. In 2019, short-term borrowings increased $130.7 million, compared with an increase of $258.3 million in 2018. There was no net change in long-term borrowings in 2019, compared with an increase of $255.1 million in 2018.
In October 2018, the Company along with certain of its foreign subsidiaries amended and restated its Credit Agreement. The Credit Agreement amends and restates the Company’s existing $850 million revolving credit facility, which was due to expire in March 2021. The amended Credit Agreement consists of a five-year revolving credit facility in an aggregate principal amount of $1.5 billion with a final maturity date in October 2023. The revolving credit facility total borrowing capacity excludes an accordion feature that permits the Company to request up to an additional $500 million in revolving credit commitments at any time during the life of the Credit Agreement under certain conditions. The revolving credit facility provides the Company with additional financial flexibility to support its growth plans, including its acquisition strategy. At December 31, 2019, the Company had available borrowing capacity of $1,580.5 million under its revolving credit facility, including the $500 million accordion feature.
In December 2018, the Company completed the 2018 private placement agreement to sell $575 million and 75 million Euros in senior notes to a group of institutional investors utilizing two funding dates. The first funding occurred in December 2018 for $475 million and 75 million Euros ($85.1 million). The second funding occurred in January 2019 for $100 million. The 2018 Private Placement senior notes carry a weighted average interest rate of 3.93% and are subject to certain customary covenants, including financial covenants that, among other things, require the Company to maintain certain
debt-to-EBITDA
and interest coverage ratios. The proceeds from the 2018 Private Placement fundings were used to pay down domestic borrowings under the Company’s revolving credit facility.
In the fourth quarter of 2019, $100 million of 6.30% senior notes matured and were paid. In the third quarter of 2018, $80 million of 6.35% senior notes and $160 million of 7.08% senior notes matured and were paid. In the fourth quarter of 2018, $65 million of 7.18% senior notes matured and were paid. The
debt-to-capital
ratio was 35.1% at December 31, 2019, compared with 38.3% at December 31, 2018. The net
debt-to-capital
ratio (total debt, net less cash and cash equivalents divided by the sum of net debt and stockholders’ equity) was 31.7% at December 31, 2019, compared with 34.9% at December 31, 2018. The net
debt-to-capital
ratio is presented because the Company is aware that this measure is used by third parties in evaluating the Company. (See the “Notes to Selected Financial Data” included in Item 6 in this Annual Report on Form
10-K
for a reconciliation of U.S. GAAP measures to comparable
non-GAAP
measures).
In 2019, the Company repurchased approximately 133,000 shares of its common stock for $11.9 million, compared with $367.7 million used for repurchases of approximately 5,079,000 shares in 2018. At December 31, 2019, $489.1 million was available under the Company’s Board of Directors authorization for future share repurchases. On February 12, 2019, the Company’s Board of Directors approved an increase of $500 million in the authorization for the repurchase of the Company’s common stock.
Additional financing activities for 2019 included cash dividends paid of $127.5 million, compared with $128.9 million in 2018. Proceeds from the exercise of employee stock options were $90.4 million in 2019, compared with $30.0 million in 2018. In the fourth quarter of 2018, the Company made a $30.0 million contingent payment related to the Rauland acquisition. Cash provided by financing activities includes $25.5 million related to the acquisition date estimated fair value of the contingent payment liability, which was based on a probabilistic approach using level 3 inputs. See Note 6 to the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form
10-K
for further details.
As a result of all of the Company’s cash flow activities in 2019, cash and cash equivalents at December 31, 2019 totaled $393.0 million, compared with $354.0 million at December 31, 2018. At December 31, 2019, the
Company had $357.9 million in cash outside the United States, compared with $311.2 million at December 31, 2018. The Company utilizes this cash to fund its international operations, as well as to acquire international businesses. The Company is in compliance with all covenants, including financial covenants, for all of its debt agreements. The Company believes it has sufficient cash-generating capabilities from domestic and unrestricted foreign sources, available credit facilities and access to long-term capital funds to enable it to meet its operating needs and contractual obligations in the foreseeable future.
Subsequent Event
Effective February 12, 2020, the Company’s Board of Directors approved a 29% increase in the quarterly cash dividend on the Company’s common stock to $0.18 per common share from $0.14 per common share.
The following table summarizes AMETEK’s contractual cash obligations and the effect such obligations are expected to have on the Company’s liquidity and cash flows in future years at December 31, 2019.
| Payments Due | ||||||||||||||||||||
| Contractual Obligations (1) | Total | Less Than One Year | One to Three Years | Four to Five Years | After Five Years | |||||||||||||||
| (In millions) | ||||||||||||||||||||
| Long-term debt borrowings (2) | $ | 2,382.1 | $ | 106.1 | $ | 56.8 | $ | 725.0 | $ | 1,494.2 | ||||||||||
| Revolving credit loans (3) | 384.8 | 384.8 | — | — | — | |||||||||||||||
| Other indebtedness | 9.2 | 9.2 | — | — | — | |||||||||||||||
| Total debt (4) | 2,776.1 | 500.1 | 56.8 | 725.0 | 1,494.2 | |||||||||||||||
| Interest on long-term fixed-rate debt | 516.2 | 73.6 | 139.0 | 134.9 | 168.7 | |||||||||||||||
| Noncancellable operating leases (5) | 208.0 | 49.4 | 76.2 | 43.4 | 39.0 | |||||||||||||||
| Purchase obligations (6) | 505.2 | 478.5 | 23.0 | 2.8 | 0.9 | |||||||||||||||
| Restructuring and other | 23.8 | 23.8 | — | — | — | |||||||||||||||
| Total | $ | 4,029.3 | $ | 1,125.4 | $ | 295.0 | $ | 906.1 | $ | 1,702.8 | ||||||||||
| (1) | The liability for uncertain tax positions was not included in the table of contractual obligations as of December 31, 2019 because the timing of the settlements of these uncertain tax positions cannot be reasonably estimated at this time. See Note 9 to the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further details. |
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| (2) | See Note 10 to the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further details. |
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| (3) | Although not contractually obligated, the Company expects to have the capability to repay the revolving credit loan within one year as permitted in the Credit Agreement. Accordingly, $384.8 million was classified as short-term debt at December 31, 2019. |
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| (4) | Excludes debt issuance costs of $7.4 million, of which $2.7 million is classified as current and $4.7 million is classified as long-term. See Note 10 to the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further details. |
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| (5) | The leases expire over a range of years from 2020 to 2034, except for a single land lease with 64 years remaining. Most of the leases contain renewal or purchase options, subject to various terms and conditions. |
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| (6) | Purchase obligations primarily consist of contractual commitments to purchase certain inventories at fixed prices. |
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Other Commitments
The Company has standby letters of credit and surety bonds of $63.8 million related to performance and payment guarantees at December 31, 2019. Based on experience with these arrangements, the Company believes that any obligations that may arise will not be material to its financial position.
Internal Reinvestment
Capital Expenditures
Capital expenditures were $102.3 million or 2.0% of net sales in 2019, compared with $82.1 million or 1.7% of net sales in 2018. In 2019, approximately 66% of capital expenditures were for improvements to existing equipment or additional equipment to increase productivity and expand capacity. Capital expenditures in 2020 are expected to be approximately 2% of net sales, with a continued emphasis on spending to improve productivity.
Research, Development and Engineering
The Company is committed to, and has consistently invested in, research, development and engineering activities to design and develop new and improved products and solutions. Research, development and engineering costs before customer reimbursement were $260.3 million in 2019, $230.2 million in 2018 and $221.2 million in 2017. Customer reimbursements in 2019, 2018 and 2017 were $3.2 million, $5.2 million and $5.4 million, respectively. These amounts included research and development expenses of $161.9 million, $141.0 million and $130.4 million in 2019, 2018 and 2017, respectively. All such expenditures were directed toward the development of new products and solutions and the improvement of existing products and solutions.
Environmental Matters
Certain historic processes in the manufacture of products have resulted in environmentally hazardous waste
by-products
as defined by federal and state laws and regulations. The Company believes these waste products were handled in compliance with regulations existing at that time. At December 31, 2019, the Company is named a Potentially Responsible Party (“PRP”) at 13
non-AMETEK-owned
former waste disposal or treatment sites (the
“non-owned”
sites). The Company is identified as a “de minimis” party in 12 of these sites based on the low volume of waste attributed to the Company relative to the amounts attributed to other named PRPs. In eight of these sites, the Company has reached a tentative agreement on the cost of the de minimis settlement to satisfy its obligation and is awaiting executed agreements. The tentatively
agreed-to
settlement amounts are fully reserved. In the other four sites, the Company is continuing to investigate the accuracy of the alleged volume attributed to the Company as estimated by the parties primarily responsible for remedial activity at the sites to establish an appropriate settlement amount. At the remaining site where the Company is a
non-de
minimis PRP, the Company is participating in the investigation and/or related required remediation as part of a PRP Group and reserves have been established sufficient to satisfy the Company’s expected obligations. The Company historically has resolved these issues within established reserve levels and reasonably expects this result will continue. In addition to these
non-owned
sites, the Company has an ongoing practice of providing reserves for probable remediation activities at certain of its current or previously owned manufacturing locations (the “owned” sites). For claims and proceedings against the Company with respect to other environmental matters, reserves are established once the Company has determined that a loss is probable and estimable. This estimate is refined as the Company moves through the various stages of investigation, risk assessment, feasibility study and corrective action processes. In certain instances, the Company has developed a range of estimates for such costs and has recorded a liability based on the best estimate. It is reasonably possible that the actual cost of remediation of the individual sites could vary from the current estimates and the amounts accrued in the consolidated financial statements; however, the amounts of such variances are not expected to result in a material change to the consolidated financial statements. In estimating the Company’s liability for remediation, the Company also considers the likely proportionate share of the anticipated remediation expense and the ability of the other PRPs to fulfill their obligations.
Total environmental reserves at December 31, 2019 and 2018 were $28.9 million and $27.8 million, respectively, for both
non-owned
and owned sites. In 2019, the Company recorded $7.0 million in reserves. Additionally, in 2019 the Company spent $6.0 million on environmental matters and the reserve increased
$0.1 million due to foreign currency translation. The Company’s reserves for environmental liabilities at December 31, 2019 and 2018 included reserves of $9.0 million and $9.6 million, respectively, for an owned site acquired in connection with the 2005 acquisition of HCC Industries (“HCC”). The Company is the designated performing party for the performance of remedial activities for one of several operating units making up a Superfund site in the San Gabriel Valley of California. The Company has obtained indemnifications and other financial assurances from the former owners of HCC related to the costs of the required remedial activities.
The Company has agreements with other former owners of certain of its acquired businesses, as well as new owners of previously owned businesses. Under certain of the agreements, the former or new owners retained, or assumed and agreed to indemnify the Company against, certain environmental and other liabilities under certain circumstances. The Company and some of these other parties also carry insurance coverage for some environmental matters. To date, these parties have met their obligations in all material respects.
The Company believes it has established reserves for the environmental matters described above, which are sufficient to perform all known responsibilities under existing claims and consent orders. The Company has no reason to believe that other third parties would fail to perform their obligations in the future. In the opinion of management, based on presently available information and the Company’s historical experience related to such matters, an adequate provision for probable costs has been made and the ultimate cost resulting from these actions is not expected to materially affect the consolidated results of operations, financial position or cash flows of the Company.
The Company has been remediating groundwater contamination for several contaminants, including trichloroethylene (“TCE”), at a formerly owned site in El Cajon, California. Several lawsuits have been filed against the Company alleging damages resulting from the groundwater contamination, including property damages and personal injury, and seeking compensatory and punitive damages. The Company believes that it has good and valid defenses to each of these claims and intends to defend them vigorously. The Company believes it has established reserves for these lawsuits that are sufficient to satisfy its expected exposure. The Company does not expect the outcome of these matters, either individually or in the aggregate, to materially affect the consolidated results of operations, financial position or cash flows of the Company.
Critical Accounting Policies
The Company has identified its critical accounting policies as those accounting policies that can have a significant impact on the presentation of the Company’s financial condition and results of operations and that require the use of complex and subjective estimates based on the Company’s historical experience and management’s judgment. Because of the uncertainty inherent in such estimates, actual results may differ materially from the estimates used. The consolidated financial statements and related notes contain information that is pertinent to the Company’s accounting policies and to Management’s Discussion and Analysis. The information that follows represents additional specific disclosures about the Company’s accounting policies regarding risks, estimates, subjective decisions or assessments whereby materially different financial condition and results of operations could have been reported had different assumptions been used or different conditions existed. Primary disclosure of the Company’s significant accounting policies is in Note 1 to the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form
10-K.
| • | Business Combinations . The Company allocates the purchase price of an acquired company, including when applicable, the acquisition date fair value of contingent consideration between tangible and intangible assets acquired and liabilities assumed from the acquired business based on their estimated fair values, with the residual of the purchase price recorded as goodwill. Third party appraisal firms and other consultants are engaged to assist management in determining the fair values of certain assets acquired and liabilities assumed. Estimating fair values requires significant judgments, estimates and assumptions, including but not limited to: discount rates, future cash flows and the economic lives of trade names, technology, customer relationships, property, plant and equipment, as well as income taxes. These estimates are based on historical experience and information obtained from the management of the acquired companies and are inherently uncertain. |
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| • | Goodwill and Other Intangible Assets. Goodwill and other intangible assets with indefinite lives, primarily trademarks and trade names, are not amortized; rather, they are tested for impairment at least annually. For the purpose of the goodwill impairment test, the Company can elect to perform a qualitative analysis to determine if it is more likely than not that the fair values of its reporting units are less than the respective carrying values of those reporting units. The Company elected to bypass performing the qualitative screen and performed the first step quantitative analysis of the goodwill impairment test in the current year. The Company may elect to perform the qualitative analysis in future periods. The first step in the quantitative process is to compare the carrying amount of the reporting unit’s net assets to the fair value of the reporting unit. If the fair value exceeds the carrying value, no further evaluation is required, and no impairment loss is recognized. An impairment charge would be recognized to the extent the carrying amount of goodwill exceeds the reporting unit fair value. |
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The Company identifies its reporting units at the component level, which is one level below its operating segments. Generally, goodwill arises from acquisitions of specific operating companies and is assigned to the reporting unit in which a particular operating company resides. The Company’s reporting units are divisions that are one level below its operating segments and for which discrete financial information is prepared and regularly reviewed by segment management.
The Company principally relies on a discounted cash flow analysis to determine the fair value of each reporting unit, which considers forecasted cash flows discounted at an appropriate discount rate. The Company believes that market participants would use a discounted cash flow analysis to determine the fair value of its reporting units in a sale transaction. The annual goodwill impairment test requires the Company to make a number of assumptions and estimates concerning future levels of revenue growth, operating margins, depreciation, amortization and working capital requirements, which are based on the Company’s
long-range
plan and are considered level 3 inputs. The Company’s long-range plan is updated as part of its annual planning process and is reviewed and approved by management. The discount rate is an estimate of the overall
after-tax
rate of return required by a market participant whose weighted average cost of capital includes both equity and debt, including a risk premium. While the Company uses the best available information to prepare its cash flow and discount rate assumptions, actual future cash flows or market conditions could differ significantly resulting in future impairment charges related to recorded goodwill balances. While there are always changes in assumptions to reflect changing business and market conditions, the Company’s overall methodology and the population of assumptions used have remained unchanged. In order to evaluate the sensitivity of the goodwill impairment test to changes in the fair value calculations, the Company applied a hypothetical 10% decrease in fair values of each reporting unit. The 2019 results (expressed as a percentage of carrying value for the respective reporting unit) showed that, despite the hypothetical 10% decrease in fair value, the fair values of the Company’s reporting units still exceeded their respective carrying values by 77% to 1,074% for each of the Company’s reporting units.
The impairment test for indefinite-lived intangibles other than goodwill (primarily trademarks and trade names) consists of a comparison of the fair value of the indefinite-lived intangible asset to the carrying value of the asset as of the impairment testing date. The Company can elect to perform a qualitative analysis to determine if it is more likely than not that the fair values of its indefinite-lived intangible assets are less than the respective carrying values of those assets. The Company elected to bypass performing the qualitative screen. The Company may elect to perform the qualitative analysis in future periods. The Company estimates the fair value of its indefinite-lived intangibles using the relief from royalty method using level 3 inputs. The Company believes the relief from royalty method is a widely used valuation technique for such assets. The fair value derived from the relief from royalty method is measured as the discounted cash flow savings realized from owning such trademarks and trade names and not having to pay a royalty for their use.
The Company’s acquisitions have generally included a significant goodwill component and the Company expects to continue to make acquisitions. At December 31, 2019, goodwill and other indefinite-lived intangible assets totaled $4,789.4 million or 48.7% of the Company’s total assets. The Company completed its required annual impairment tests in the fourth quarter of 2019 and determined that the carrying values of the Company’s goodwill and indefinite-lived intangibles were not impaired. There can be no assurance that goodwill or indefinite-lived intangibles impairment will not occur in the future.
Other intangible assets with finite lives are evaluated for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. The carrying value of other intangible assets with finite lives is considered impaired when the total projected undiscounted cash flows from those assets are separately identifiable and are less than the carrying value. In that event, a loss is recognized based on the amount by which the carrying value exceeds the fair value of those assets. Fair value is determined primarily using present value techniques based on projected cash flows from the asset group.
| • | Pensions. The Company has U.S. and foreign defined benefit and defined contribution pension plans. The most significant elements in determining the Company’s pension income or expense are the assumed pension liability discount rate and the expected return on plan assets. The pension discount rate reflects the current interest rate at which the pension liabilities could be settled at the valuation date. At the end of each year, the Company determines the assumed discount rate to be used to discount plan liabilities. In estimating this rate for 2019, the Company considered rates of return on high-quality, fixed-income investments that have maturities consistent with the anticipated funding requirements of the plan. In estimating the U.S. and foreign discount rates, the Company’s actuaries developed a customized discount rate appropriate to the plans’ projected benefit cash flow based on yields derived from a database of long-term bonds at consistent maturity dates. The Company determines the expected long-term rate of return based primarily on its expectation of future returns for the pension plans’ investments. Additionally, the Company considers historical returns on comparable fixed-income and equity investments and adjusts its estimate as deemed appropriate. |
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| • | Income Taxes. The process of providing for income taxes and determining the related balance sheet accounts requires management to assess uncertainties, make judgments regarding outcomes and utilize estimates. The Company conducts a broad range of operations around the world and is therefore subject to complex tax regulations in numerous international taxing jurisdictions, resulting at times in tax audits, disputes and potential litigation, the outcome of which is uncertain. Management must make judgments currently about such uncertainties and determine estimates of the Company’s tax assets and liabilities. To the extent the final outcome differs, future adjustments to the Company’s tax assets and liabilities may be necessary. |
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The Company assesses the realizability of its deferred tax assets, taking into consideration the Company’s forecast of future taxable income, available net operating loss carryforwards and available tax planning strategies that could be implemented to realize the deferred tax assets. Based on this assessment, management must evaluate the need for, and the amount of, valuation allowances against the Company’s deferred tax assets. To the extent facts and circumstances change in the future, adjustments to the valuation allowances may be required.
The Company assesses the uncertainty in its tax positions, by applying a minimum recognition threshold which a tax position is required to meet before a tax benefit is recognized in the financial statements. Once the minimum threshold is met, using a more likely than not standard, a series of probability estimates is made for each item to properly measure and record a tax benefit. The tax benefit recorded is generally equal to the highest probable outcome that is more than 50% likely to be realized after full disclosure and resolution of a tax examination. The underlying probabilities are determined based on the best available objective evidence such as recent tax audit outcomes, published guidance, external expert opinion, or by analogy to the outcome of similar issues in the past. There can be no assurance that these estimates will ultimately be realized given continuous changes in tax policy, legislation and audit practice. The Company recognizes interest and penalties accrued related to uncertain tax positions in income tax expense.
Recent Accounting Pronouncements
See Note 2, Recent Accounting Pronouncements, to the Company’s Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form
10-K
for information regarding recently issued accounting pronouncements.
Forward-Looking Information
Certain matters discussed in this Form
10-K
are “forward-looking statements” as defined in the Private Securities Litigation Reform Act of 1995 (“PSLRA”), which involve risk and uncertainties that exist in the Company’s operations and business environment and can be affected by inaccurate assumptions, or by known or unknown risks and uncertainties. Many such factors will be important in determining the Company’s actual future results. The Company wishes to take advantage of the “safe harbor” provisions of the PSLRA by cautioning readers that numerous important factors in some cases have caused, and in the future could cause, the Company’s actual results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company. Some, but not all, of the factors or uncertainties that could cause actual results to differ from present expectations are set forth above and under Item 1A. Risk Factors. The Company undertakes no obligation to publicly update any forward-looking statements, whether as a result of new information, subsequent events or otherwise, unless required by the securities laws to do so.
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