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
Fortive is a diversified industrial growth company comprised of Professional Instrumentation and Industrial Technologies segments and encompassing businesses that are recognized leaders in attractive markets. Our well-known brands hold leading positions in advanced instrumentation solutions, transportation technology, sensing, and franchise distribution markets. Our businesses design, develop, service, manufacture and market professional and engineered products, software and services for a variety of end markets, building upon leading brand names, innovative technology and significant market positions. Our research and development, manufacturing, sales, distribution, service and administrative facilities are located in more than 50 countries across North America, Asia Pacific, Europe and Latin America.
This MD&A is designed to provide a reader of our financial statements with a narrative from the perspective of management. Our MD&A is divided into eight sections:
| • | Basis of Presentation |
| • | Overview |
| • | Results of Operations |
| • | Financial Instruments and Risk Management |
| • | Liquidity and Capital Resources |
| • | Critical Accounting Estimates |
| • | New Accounting Standards |
| • | Separation from Danaher |
BASIS OF PRESENTATION
On March 7, 2018, we entered into a definitive agreement to combine four of our operating companies from our Automation & Specialty platform (the “A&S Business”) with Altra Industrial Motion Corp. (“Altra”) in a tax-efficient Reverse Morris Trust transaction. On October 1, 2018, we completed the split-off of the A&S Business and have presented the results of operations of the A&S Business in our Consolidated and Combined Statements of Income, and the related assets and liabilities in the Consolidated Balance Sheets as discontinued operations. These changes have been applied to all periods presented. Unless otherwise noted, amounts, percentages and discussion for all periods included in Management’s Discussion and Analysis reflect the results of operations and financial condition from our continuing operations. Refer to Note 4 to our consolidated and combined financial statements for additional information on discontinued operations.
We completed the Separation from Danaher Corporation on July 2, 2016, the first day of our fiscal third quarter of 2016 (“the Separation”). Before that date, Fortive was a wholly-owned subsidiary of Danaher and our businesses were comprised of certain Danaher operating units. Danaher transferred these businesses to us prior to the Separation. The Separation was completed in the form of a pro rata distribution by Danaher to its stockholders of record on June 15, 2016, of all of the outstanding shares of Fortive held by Danaher. Fortive was incorporated in the state of Delaware on November 10, 2015 in order to facilitate the Separation.
OVERVIEW
General
Fortive is a multinational business with global operations. Please see “Item 1. Business – General” included in this Annual Report for a discussion of the Company’s strategies for delivering long-term shareholder value. During 2018, approximately 45% of our sales were derived from customers outside the United States. As a diversified industrial growth company with global operations, our businesses are affected by worldwide, regional and industry-specific economic and political factors. Our geographic and industry diversity, as well as the range of our products, software and services, typically help limit the impact of any one industry or the economy of any single country (except for the United States) on our operating results. Given the broad range of products manufactured, software and services provided and geographies served, we do not use any indices other than general economic trends to predict the overall outlook for the Company. Our individual businesses monitor key competitors and customers, including to the extent possible their sales, to gauge relative performance and the outlook for the future.
As a result of our geographic and industry diversity, we face a variety of opportunities and challenges, including technological development in most of the markets we serve, the expansion and evolution of opportunities in high-growth markets, trends and costs associated with a global labor force and consolidation of our competitors. We define high-growth markets as developing markets of the world experiencing extended periods of accelerated growth in gross domestic product and infrastructure which include Eastern Europe, the Middle East, Africa, Latin America and Asia with the exception of Japan and Australia. We operate in a highly competitive business environment in most markets, and our long-term growth and profitability will depend in particular on our ability to expand our business across geographies and market segments, identify, consummate and integrate appropriate acquisitions, develop innovative and differentiated new products, services and software, expand and improve the effectiveness of our sales force, continue to reduce costs and improve operating efficiency and quality, and effectively address the demands of an increasingly regulated environment. We are making significant investments, organically and through acquisitions, to address technological change in the markets we serve and to improve our manufacturing, research and development and customer-facing resources in order to be responsive to our customers throughout the world.
In this report, references to sales from existing businesses refers to sales from operations calculated according to GAAP but excluding (1) sales impacts from acquired businesses, (2) sales impacts from the Separation and (3) the impact of currency translation. References to sales or operating profit attributable to acquisitions or acquired businesses refer to GAAP sales or operating profit, as applicable, from acquired businesses recorded prior to the first anniversary of the acquisition less the amount of sales or operating profit, as applicable, attributable to certain divested businesses or product lines not considered discontinued operations prior to the first anniversary of the divestiture. Sales impacts from the Separation refer to sales to or from Danaher made under agreements entered into, or terminated, in connection with the Separation prior to the first anniversary of the Separation. The portion of sales attributable to the impact of currency translation is calculated as the difference between (a) the period-to-period change in sales (excluding sales from acquired businesses or the Separation) and (b) the period-to-period change in sales (excluding sales from acquired businesses or the Separation) after applying the current period foreign exchange rates to the prior year period. Sales from existing businesses should be considered in addition to, and not as a replacement for or superior to, sales, and may not be comparable to similarly titled measures reported by other companies.
Management believes that reporting the non-GAAP financial measure of sales from existing businesses provides useful information to investors by helping identify underlying growth trends in our business and facilitating easier comparisons of our sales performance with our performance in prior and future periods and to our peers. We exclude the effect of acquisitions and divestiture related items (including the impact of agreements with Danaher that were entered into or terminated in connection with the Separation) because the nature, size and number of such transactions can vary dramatically from period to period and between us and our peers. In addition, we exclude the impact of agreements that were terminated, or entered into, in connection with the Separation because we believe that excluding such impact may be useful to investors in assessing our operational performance independent of the impact on sales to or from Danaher resulting primarily from the Separation. We exclude the effect of currency translation from sales from existing businesses because currency translation is not under management’s control and is subject to volatility. Management believes the exclusion of the effect of acquisition and divestiture (including Separation-related items) and currency translation may facilitate assessment of underlying business trends and may assist in comparisons of long-term performance. References to sales volume refer to the impact of both price and unit sales.
Business Performance and Outlook
While differences exist among our businesses, on an overall basis, demand for our hardware and software products, and services increased during 2018 as compared to 2017 resulting in aggregate year-over-year sales growth of 12.1% and sales growth from existing businesses of 4.1%. Our continued application and deployment of the Fortive Business System including investments in sales growth initiatives and new product introductions, as well as increased demand in both high-growth and developed markets and other business-specific factors discussed below contributed to overall sales growth from existing businesses.
On a year-over-year basis, sales growth from existing businesses in the Professional Instrumentation segment was driven by strong demand in the businesses within both Advanced Instrumentation & Solutions and Sensing Technologies. In our Industrial Technologies segment, the liability shift related to enhanced credit card security requirements in the United States based on the Europay, Mastercard and Visa (“EMV”) global standards is continuing to drive demand within our transportation technologies businesses. EMV is expected to continue to drive increased demand for dispensers and payment systems in 2019.
Geographically, sales from existing businesses grew at a mid-single digit rate in both high-growth and developed markets during 2018 as compared to 2017. Year-over-year sales from existing businesses grew at a mid-single digit rate in North America and Asia, with low double-digit rate growth in China, while sales from existing businesses were flat in Western Europe.
We expect overall sales from existing businesses to continue to grow on a year-over-year basis during 2019; however, we continue to monitor developments from macro-economic and geopolitical uncertainties, including global uncertainties related to governmental policies toward international trade, monetary and fiscal policies, including the current uncertainty about the future relationship between the United States and China with respect to trade policies, treaties, government regulations, and tariffs, as well as other factors identified in “Item 1A. Risk Factors.”
Completed Acquisitions
2018
Gordian
On July 27, 2018, we acquired TGG Ultimate Holdings, Inc. and its subsidiaries, including The Gordian Group, Inc. (“Gordian”), a privately-held, leading provider of construction cost data, software and service, for a total purchase price of $778 million net of cash acquired (the “Gordian Acquisition”). Gordian’s comprehensive offerings serve the entire building lifecycle and provide workflow solutions designed to optimize every stage of an asset owner’s construction and maintenance needs, including connecting the owner and contractors in the same exchange and providing access to cost and facility metrics databases via a subscription-based model. We preliminarily recorded approximately $429 million of goodwill related to the Gordian Acquisition.
Accruent
On September 6, 2018, we acquired Athena SuperHoldCo, Inc., including Accruent, LLC (“Accruent”), a privately-held, leading provider of facilities asset management software, for a total purchase price of approximately $2.0 billion net of acquired cash (the “Accruent Acquisition”). Accruent is a recognized leader in the facilities asset management industry, combining deep domain and industry capabilities with an integrated, cloud-based framework that provides insights spanning the full lifecycle of real estate, facilities and asset management. Accruent serves over 10,000 global customers, and helps assure clients fulfill the mission of their organization by extending the lifecycle of assets, monitoring full compliance and reducing safety risks. We preliminarily recorded approximately $1.1 billion of goodwill related to the Accruent Acquisition.
In addition to the acquisitions of Accruent and Gordian, during 2018, we acquired two businesses for total consideration of $44 million in cash, net of cash acquired. The businesses acquired complement existing units of both our segments. We preliminarily recorded an aggregate of $31 million of goodwill related to these acquisitions.
2017
During 2017, we acquired three businesses for total consideration of $1.56 billion in cash, net of cash acquired. The businesses acquired complement existing units of both our segments. The aggregate annual sales of these businesses at the time of their respective acquisitions, in each case based on the acquired company’s revenues for its last completed fiscal year prior to the acquisition, were approximately $389 million. We recorded an aggregate of $1.04 billion of goodwill related to these acquisitions.
2016
During 2016, we acquired three businesses for total consideration of $190 million in cash, net of cash acquired. The businesses acquired complement existing units of both our segments. The aggregate annual sales of these businesses at the time of their respective acquisitions, in each case based on the acquired company’s revenues for its last completed fiscal year prior to the acquisition, were approximately $47 million. We recorded an aggregate of $113 million of goodwill related to these acquisitions.
Pending Acquisition
On June 6, 2018, we made a binding offer to Ethicon, Inc., a subsidiary of Johnson & Johnson, to purchase its Advanced Sterilization Products (“ASP”) business for approximately $2.7 billion in cash. On September 20, 2018, Ethicon, Inc. accepted our offer and countersigned the purchase agreement. The transaction is expected to close after the end of the first quarter of 2019 and is subject to customary closing conditions.
ASP is a leading global provider of innovative sterilization and disinfection solutions and pioneered low-temperature hydrogen peroxide sterilization technology. ASP’s products, which are sold globally, include the STERRAD system for sterilizing instruments and the EVOTECH and ENDOCLENS systems for endoscope reprocessing and cleaning.
Divestiture of A&S Business
On March 7, 2018, we entered into a definitive agreement to combine four of our operating companies from our Automation & Specialty platform (the “A&S Business”) with Altra Industrial Motion Corp. (“Altra”) in a tax-efficient Reverse Morris Trust transaction. The A&S Business includes the market-leading brands of Kollmorgen, Thomson, Portescap and Jacobs Vehicle Systems, and generated approximately $900 million in revenue for the year ended December 31, 2017. On October 1, 2018, we completed the split-off of the A&S Business. The total consideration received was $2.7 billion and consisted of (i) $1.3 billion through a fully-subscribed exchange offer, in which we accepted and subsequently retired 15,824,931 shares of our own common stock from our stockholders in exchange for 35,000,000 shares of common stock of Stevens Holding Company, Inc.; (ii) $1.0 billion in cash paid to us for the direct sales of certain assets and liabilities of the A&S Business; (iii) $250.0 million as part of a non-cash debt-for-debt exchange that reduced outstanding indebtedness of Fortive, which is inclusive of accrued interest and fees; and (iv) $150 million in cash paid to us by Stevens Holding Company, Inc. as a dividend. The results of the A&S Business are reported as discontinued operations for all periods presented, which includes the after-tax gain on the transaction of $1.9 billion.
RESULTS OF OPERATIONS
Components of Sales Growth
| 2018 vs. 2017 | 2017 vs. 2016 | ||||
| Total revenue growth (GAAP) | 12.1 | % | 7.0 | % | |
| Existing businesses (Non-GAAP) | 4.1 | % | 4.2 | % | |
| Acquisitions (a) (Non-GAAP) | 7.6 | % | 2.5 | % | |
| Currency exchange rates (Non-GAAP) | 0.4 | % | 0.3 | % | |
| (a) Includes the impact from both acquisitions and the Separation |
Refer to —Professional Instrumentation and —Industrial Technologies sections below for further discussion of year-over-year sales growth.
Operating Profit Margins
Operating profit margins were 18.3% for the year ended December 31, 2018, a decrease of 160 basis points as compared to 19.9% in 2017.
Year-over-year operating profit margin comparisons were favorably impacted by:
| • | Higher 2018 sales volumes from existing businesses, price increases, incremental year-over-year cost savings associated with restructuring and productivity improvement initiatives and changes in currency exchange rates, which were partially offset by incremental year-over-year costs associated with various product development and sales and marketing growth investments, incremental general and administrative expenses, depreciation and amortization associated with acquisitions completed in prior years, and increased material costs associated primarily with inflationary pressures and recently enacted tariffs — 35 basis points |
Year-over-year operating profit margin comparisons were unfavorably impacted by:
| • | Acquisition-related transaction costs and acquisition-related restructuring — 75 basis points |
| • | The incremental year-over-year net dilutive effect of acquired businesses — 120 basis points |
Operating profit margins were 19.9% for the year ended December 31, 2017, an increase of 20 basis points as compared to 19.7% in 2016.
Year-over-year operating profit margin comparisons were favorably impacted by:
| • | Higher 2017 sales volumes, incremental year-over-year cost savings associated with restructuring and productivity improvement initiatives, lower year-over-year intangible asset amortization due to certain intangible assets, primarily in our Professional Instrumentation segment, being fully amortized, costs associated with various growth investments made in 2016 and changes in currency exchange rates, net of the incremental year-over-year costs associated with various product development and sales and marketing growth investments and increased general and administrative costs required to operate as a stand-alone public company — 90 basis points |
Year-over-year operating profit margin comparisons were unfavorably impacted by:
| • | Acquisition-related transaction costs and acquisition-related restructuring — 30 basis points |
| • | The incremental year-over-year net dilutive effect of acquired businesses — 40 basis points |
Business Segments and Geographic Area Results
Sales by business segment and geographic area for the year ended December 31 are as follows ($ in millions):
| 2018 | 2017 | 2016 | |||||||||
| Segments | |||||||||||
| Professional Instrumentation | $ | 3,655.1 | $ | 3,139.1 | $ | 2,891.6 | |||||
| Industrial Technologies | 2,797.6 | 2,617.0 | 2,486.6 | ||||||||
| Total | $ | 6,452.7 | $ | 5,756.1 | $ | 5,378.2 | |||||
| Geographic area | |||||||||||
| United States | $ | 3,539.6 | $ | 3,148.7 | $ | 3,028.8 | |||||
| China | 569.0 | 498.4 | 458.9 | ||||||||
| Germany | 234.7 | 217.2 | 180.5 | ||||||||
| All other (each country individually less than 5% of total sales) | 2,109.4 | 1,891.8 | 1,710.0 | ||||||||
| Total | $ | 6,452.7 | $ | 5,756.1 | $ | 5,378.2 |
PROFESSIONAL INSTRUMENTATION
The Professional Instrumentation segment consists of our Advanced Instrumentation & Solutions and Sensing Technologies businesses. The Advanced Instrumentation & Solutions businesses provide product realization and field solutions services and products. Field solutions products include a variety of compact professional test tools, thermal imaging and calibration equipment for electrical, industrial, electronic and calibration applications, online condition-based monitoring equipment; portable gas detection equipment, consumables, and software as a service (SaaS) offerings including safety/user behavior, asset management, and compliance monitoring; subscription-based technical, analytical, and compliance services to determine occupational and environmental radiation exposure; and software, data analytics and services for critical infrastructure in utility, industrial, energy, construction, facilities management, public safety, mining, and healthcare applications. Product realization services and products help developers and engineers across the end-to-end product creation cycle from concepts to finished products and also include highly-engineered energetic materials components in specialized vertical applications. Our Sensing Technologies business offers devices that sense, monitor and control operational or manufacturing variables, such as temperature, pressure, level, flow, turbidity and conductivity.
Professional Instrumentation Selected Financial Data
| For the Year Ended December 31 | |||||||||||
| ($ in millions) | 2018 | 2017 | 2016 | ||||||||
| Sales | $ | 3,655.1 | $ | 3,139.1 | $ | 2,891.6 | |||||
| Operating profit | 749.6 | 712.9 | 645.1 | ||||||||
| Depreciation | 64.4 | 41.9 | 35.6 | ||||||||
| Amortization | 104.3 | 40.1 | 63.8 | ||||||||
| Operating profit as a % of sales | 20.5 | % | 22.7 | % | 22.3 | % | |||||
| Depreciation as a % of sales | 1.8 | % | 1.3 | % | 1.2 | % | |||||
| Amortization as a % of sales | 2.9 | % | 1.3 | % | 2.2 | % |
Components of Sales Growth
| 2018 vs. 2017 | 2017 vs. 2016 | ||||
| Total revenue growth (GAAP) | 16.4 | % | 8.6 | % | |
| Existing businesses (Non-GAAP) | 3.9 | % | 5.5 | % | |
| Acquisitions (Non-GAAP) | 11.8 | % | 3.0 | % | |
| Currency exchange rates (Non-GAAP) | 0.7 | % | 0.1 | % |
2018 COMPARED TO 2017
Sales from existing businesses in the segment’s Advanced Instrumentation & Solutions businesses grew at a mid-single digit rate during 2018 as compared to 2017. Year-over-year sales from existing businesses of field solutions products and services
grew at a mid-single digit rate during 2018 as compared to 2017 due to continued broad-based demand across our product offerings, most notably for industrial test equipment, network tools and SaaS offerings, offset somewhat by declines in demand for electrical grid condition-based monitoring equipment. Growth from existing businesses was also broad-based geographically, with strong growth in North America and China.
Year-over-year sales from existing businesses of product realization solutions grew at a low-single digit rate during 2018 driven primarily by increased demand for oscilloscopes, new product introductions, and our energetic materials business, which were partially offset by declines for our products in the 3D sensing market. Geographically, demand from existing businesses increased on a year-over-year basis in North America, Western Europe and China.
Sales from existing businesses in the segment’s Sensing Technologies businesses grew at a mid-single digit rate during 2018 as compared to 2017 due to increased year-over-year demand in the industrial, medical, and energy end markets. Geographically, demand from existing businesses increased on a year-over-year basis in China, Western Europe and North America.
Price increases are reflected as a component of the change in sales from existing businesses, and year-over-year price increases in the segment contributed 0.7% to sales growth during 2018 as compared to 2017.
Operating profit margin decreased 220 basis points during 2018 as compared to 2017.
Year-over-year operating profit margin comparisons were favorably impacted by:
| • | Higher 2018 sales volumes from existing businesses, price increases, incremental year-over-year cost savings associated with restructuring and productivity improvement initiatives, and changes in currency exchange rates, net of incremental year-over-year costs associated with various product development and sales and marketing growth investments, incremental depreciation and amortization from acquisitions completed in prior years, and increased material costs associated primarily with inflationary pressures and recently enacted tariffs — 110 basis points |
Year-over-year operating profit margin comparisons were unfavorably impacted by:
| • | The incremental year-over-year net dilutive effect of acquired businesses, including amortization and acquisition-related fair value adjustments to deferred revenue — 210 basis points |
| • | Acquisition-related transaction costs, including costs related to our pending acquisition of ASP, and acquisition-related restructuring — 120 basis points |
2017 COMPARED TO 2016
Sales from existing businesses in the segment’s Advanced Instrumentation & Solutions businesses grew at a mid-single digit rate during 2017 as compared to 2016. Year-over-year sales from existing businesses of field solutions products and services grew at a mid-single digit rate during 2017 as compared to 2016 due to increased demand for industrial test equipment, network tools and online condition-based monitoring equipment. Year-over-year sales from existing businesses of product realization solutions grew at a high-single digit rate during 2017 driven primarily by continued growth in the semiconductor and consumer electronics end markets as well as increased demand for oscilloscopes and new product introductions but were partly offset by a decline in demand for design, engineering and manufacturing services. Sales in the segment’s energetic materials business also contributed to growth during 2017. Geographically, demand from existing businesses increased on a year-over-year basis in Asia, driving strong growth in high-growth markets, as well as in Western Europe and North America.
Sales from existing businesses in the segment’s Sensing Technologies businesses grew at a mid-single digit rate during 2017 as compared to 2016. Increased year-over-year demand in the industrial end market was partly offset by lower demand in the medical end market. Geographically, increases in demand on a year-over-year basis were driven by growth in Asia, North America and Western Europe.
Year-over-year price increases in the segment contributed 0.6% to sales growth during 2017 as compared to 2016 and are reflected as a component of the change in sales from existing businesses.
Operating profit margin increased 40 basis points during 2017 as compared to 2016.
Year-over-year operating profit margin comparisons were favorably impacted by:
| • | Higher 2017 sales volumes, incremental year-over-year cost savings associated with restructuring and productivity improvement initiatives, lower year-over-year intangible asset amortization due to certain intangible assets being fully amortized and changes in currency exchange rates, net of incremental year-over-year costs associated with various |
product development and sales and marketing growth investments, the positive impact in 2016 of a transition services agreement related to a disposition made by Danaher prior to the Separation and incremental year-over-year bad debt charges — 190 basis points
Year-over-year operating profit margin comparisons were unfavorably impacted by:
| • | Acquisition-related transaction costs and acquisition-related restructuring — 70 basis points |
| • | The incremental year-over-year net dilutive effect of acquired businesses — 80 basis points |
INDUSTRIAL TECHNOLOGIES
The Industrial Technologies segment consists of our Transportation Technologies and Franchise Distribution businesses. Our Transportation Technologies business is a leading worldwide provider of solutions and services focused on fuel dispensing, remote fuel management, point-of-sale and payment systems, environmental compliance, vehicle tracking and fleet management, and traffic management. Our Franchise Distribution business manufactures and distributes professional tools and a full-line of wheel service equipment.
Industrial Technologies Selected Financial Data
| For the Year Ended December 31 | |||||||||||
| ($ in millions) | 2018 | 2017 | 2016 | ||||||||
| Sales | $ | 2,797.6 | $ | 2,617.0 | $ | 2,486.6 | |||||
| Operating profit | 525.6 | 503.6 | 480.3 | ||||||||
| Depreciation | 57.9 | 45.4 | 38.7 | ||||||||
| Amortization | 30.8 | 24.9 | 21.5 | ||||||||
| Operating profit as a % of sales | 18.8 | % | 19.2 | % | 19.3 | % | |||||
| Depreciation as a % of sales | 2.1 | % | 1.7 | % | 1.6 | % | |||||
| Amortization as a % of sales | 1.1 | % | 1.0 | % | 0.9 | % |
Components of Sales Growth
| 2018 vs. 2017 | 2017 vs. 2016 | ||||
| Total revenue growth (GAAP) | 6.9 | % | 5.2 | % | |
| Existing businesses (Non-GAAP) | 4.4 | % | 2.7 | % | |
| Acquisitions (a) (Non-GAAP) | 2.6 | % | 2.0 | % | |
| Currency exchange rates (Non-GAAP) | (0.1 | )% | 0.5 | % | |
| (a) Includes the impact from acquisitions, divestitures, and the Separation |
2018 COMPARED TO 2017
Sales from existing businesses in the segment’s Transportation Technologies businesses grew at a mid-single digit rate during 2018 as compared to 2017 due primarily to strong demand for dispensers and payment solutions in North America, as well as strong demand for fuel management systems in North America, India and China. Results in North America were favorably impacted by the approaching deadline for the liability shift related to EMV global standards. Geographically, sales from existing businesses increased on a year-over-year basis in North America and in high growth markets, led by China, partially offset by declines in Western Europe.
Sales from existing businesses in the segment’s Franchise Distribution businesses grew at a low-single digit rate during 2018 as compared to 2017 largely driven by increased year-over-year demand for hardline and diagnostic tools, and tool storage products.
Price increases are reflected as a component of the change in sales from existing businesses and year-over-year price increases contributed 0.8% to sales growth in the segment during 2018 as compared to 2017.
Operating profit margin decreased 40 basis points during 2018 as compared to 2017. Higher 2018 sales volumes from existing businesses, price increases and incremental year-over-year cost savings associated with restructuring and productivity
improvement initiatives, were equally offset by continued investments in our sales and marketing growth initiatives and unfavorable sales mix.
Year-over-year operating profit margin comparisons were unfavorably impacted by 40 basis points due to the incremental year-over-year net dilutive effect of acquired businesses.
2017 COMPARED TO 2016
Sales from existing businesses in the segment’s Transportation Technologies businesses grew at a low-single digit rate during 2017 as compared to 2016 due primarily to strong demand for dispensers and payment systems in both the United States and Europe, partly offset by decreased year-over-year EMV-related demand for indoor point-of-sale systems in the United States as customers had largely upgraded to products that support indoor EMV requirements in the prior year in response to the indoor liability shift. Geographically, sales from existing businesses increased on a year-over-year basis in Europe, Latin America and the United States, partially offset by declines in the Asia-Pacific region.
Sales from existing businesses in the segment’s Franchise Distribution businesses grew at a low-single digit rate during 2017 as compared to 2016. Increased year-over-year demand for hardline and diagnostic tools was partially offset by a decline in demand for powered and tool storage products.
Year-over-year price increases in the segment contributed 0.1% to sales growth during 2017 as compared to 2016 and are reflected as a component of the change in sales from existing businesses.
Operating profit margin decreased 10 basis points during 2017 as compared to 2016.
Year-over-year operating profit margin comparisons were favorably impacted by:
| • | Higher 2017 sales volumes, incremental year-over-year cost savings associated with restructuring and productivity improvement initiatives, costs associated with various growth investments made in 2016 and changes in currency exchange rates, partially offset by incremental year-over-year costs associated with various product development and sales and marketing growth investments — 10 basis points |
Year-over-year operating profit margin comparisons were unfavorably impacted by:
| • | The incremental year-over-year net dilutive effect of acquired businesses — 20 basis points |
COST OF SALES AND GROSS PROFIT
| For the Year Ended December 31 | |||||||||||
| ($ in millions) | 2018 | 2017 | 2016 | ||||||||
| Sales | $ | 6,452.7 | $ | 5,756.1 | $ | 5,378.2 | |||||
| Cost of sales | (3,131.4 | ) | (2,834.7 | ) | (2,692.7 | ) | |||||
| Gross profit | 3,321.3 | 2,921.4 | 2,685.5 | ||||||||
| Gross profit margin | 51.5 | % | 50.8 | % | 49.9 | % |
The year-over-year increase in cost of sales during 2018 as compared to 2017 is due primarily to the impact of higher year-over-year sales volumes from existing businesses, incremental cost of sales from our recently acquired businesses, and increased material costs associated primarily with inflationary pressures and recently enacted tariffs, partly offset by incremental year-over-year cost savings associated with restructuring and productivity improvement initiatives and material cost and supply chain improvement actions. Changes in currency exchange rates increased costs of sales in 2018.
The year-over-year increase in gross profit (and the related 70 basis point increase in gross profit margin) during 2018 as compared to 2017 is due primarily to the favorable impact of pricing improvements and higher year-over-year sales volumes from existing businesses, incremental year-over-year cost savings associated with restructuring and productivity improvement initiatives, material cost and supply chain improvement actions, and the impact of recently acquired businesses. Increased material costs associated primarily with inflationary pressures and recently enacted tariffs and changes in foreign currency exchange rates partially offset the factors described above.
The year-over-year increase in cost of sales during 2017 as compared to 2016 is due primarily to the impact of higher year-over-year sales volumes, incremental year-over-year cost savings associated with restructuring actions and changes in currency exchange rates partly offset by material cost and supply chain improvement actions and costs associated with various growth investments in 2016.
The year-over year increase in gross profit (and the related 90 basis point increase in gross profit margin) during 2017 as compared to 2016 is due primarily to the favorable impact of pricing improvements and higher year-over-year sales volumes, incremental year-over-year cost savings associated with restructuring actions, continued productivity and material cost and supply chain improvement actions, partly offset by incremental year-over-year costs associated with various growth investments and higher year-over-year costs associated with restructuring actions.
OPERATING EXPENSES
| For the Year Ended December 31 | |||||||||||
| ($ in millions) | 2018 | 2017 | 2016 | ||||||||
| Sales | $ | 6,452.7 | $ | 5,756.1 | $ | 5,378.2 | |||||
| Sales, general and administrative (“SG&A”) expenses | 1,728.6 | 1,409.1 | 1,272.8 | ||||||||
| Research and development (“R&D”) expenses | 414.3 | 369.3 | 351.0 | ||||||||
| SG&A as a % of sales | 26.8 | % | 24.5 | % | 23.7 | % | |||||
| R&D as a % of sales | 6.4 | % | 6.4 | % | 6.5 | % |
SG&A expenses increased during 2018 as compared to 2017 due primarily to transaction costs associated with the announced acquisitions, incremental year-over-year depreciation and amortization from our businesses we acquired over the last two years, continued investments in our sales and marketing growth initiatives and changes in foreign currency exchange rates. These increases were partly offset by incremental year-over-year cost savings associated with restructuring and productivity improvement initiatives. SG&A expenses as a percentage of sales increased 230 basis points in 2018 as compared to 2017.
SG&A expenses increased during 2017 as compared to 2016 due primarily to continued investments in our sales and marketing growth initiatives, increased acquisition-related transaction costs and increased general and administrative costs required to operate as a stand-alone public company as compared to the allocations derived from Danaher in the periods prior to the Separation, which primarily impacted the first half of 2017 as compared to the first half of 2016. These increases were partly offset by incremental year-over-year cost savings associated with restructuring and productivity improvement initiatives and lower year-over-year intangible asset amortization due to certain intangible assets, primarily in our Professional Instrumentation segment, being fully amortized. SG&A expenses as a percentage of sales increased 80 basis points in 2017 as compared to 2016.
R&D expenses (consisting principally of internal and contract engineering personnel costs) increased during 2018 as compared to 2017 due to incremental year-over-year investments in our product development initiatives and expenses from businesses we acquired over the last two years. On a year-over-year basis, R&D expenses as a percentage of sales were flat as the investments in our product development initiatives grew at the same rate as sales.
R&D expenses increased during 2017 as compared to 2016 due to incremental year-over-year investments in our product development initiatives. On a year-over-year basis, R&D expenses as a percentage of sales decreased 10 basis points due primarily to the impact of sales growing at a faster rate than R&D expenses during the period.
INTEREST COSTS
For a discussion of our outstanding indebtedness, refer to Note 10 to the Consolidated and Combined Financial Statements.
Interest expense of $97 million was recorded during 2018 compared to $89 million during 2017 and $46 million during 2016. Interest expense increased in 2018 due to higher average debt balances during the year. In the event that additional liquidity is required, particularly in connection with acquisitions, we may enter into additional borrowings under our commercial paper programs or credit facilities and/or access the capital markets. If we enter into such additional financing transactions, the amount of annual interest expense will increase.
INCOME TAXES
General
Income tax expense and deferred tax assets and liabilities reflect management’s assessment of future taxes expected to be paid on items reflected in our financial statements. We record the tax effect of discrete items and items that are reported net of their tax effects in the period in which they occur.
On December 22, 2017, the U.S. enacted comprehensive tax reform commonly referred to as the Tax Cuts and Jobs Act (the “TCJA”). The TCJA represents a significant overhaul to the U.S. federal tax code. The TCJA impacts, among other things, U.S.
corporate tax rates, business-related exclusions, deductions, and credits. During 2018, the U.S. Treasury Department issued significant initial guidance. We have completed the accounting for all the impacts of the TCJA based upon the proposed regulations and guidance already provided by federal authorities as of December 31, 2018.
The U.S. Government is still issuing significant amounts of TCJA guidance that we expect to continue into the foreseeable future. On January 15, 2019, Treasury and the Internal Revenue Service issued final Treasury Regulations under Section 965 of the Internal Revenue Code involving the one-time transition tax on international earnings. These final Treasury Regulations are retroactive to the enactment of Section 965 of the TCJA on December 22, 2017. The Company is evaluating the impact of these final Treasury Regulations on the application of Section 965 to the Company’s unremitted international earnings. Any future adjustments resulting from guidance issued after December 31, 2018 will be considered as discrete income tax expense or benefit in the interim period the guidance is issued.
The Company continues to expect that the TCJA will have a favorable impact on our financial statements for the foreseeable future and our future ability to engage in acquisition activities.
Our effective tax rate can be affected by, among others, changes in the mix of earnings in countries with differing statutory tax rates (including as a result of business acquisitions and dispositions), changes in the valuation of deferred tax assets and liabilities, accruals related to contingent tax liabilities and period-to-period changes in such accruals, the results of audits and examinations of previously filed tax returns (as discussed below), the expiration of statutes of limitations, the implementation of tax planning strategies, tax rulings, court decisions, settlements with tax authorities and changes in tax laws, including legislative policy changes that may result from the Organization for Economic Co-operation and Development’s (“OECD”) initiative on Base Erosion and Profit Shifting.
The OECD has issued significant global tax policy changes that include both expanded reporting as well as technical global tax policy changes. Many countries in which we operate have implemented tax law and administrative changes that align with many aspects of the OECD policy guidelines. We have taken comprehensive measures to address the requirements of these changes in global tax policy. We do not expect these global tax policy changes to have a significant impact on our results of operations or cash flows.
We conduct business globally, and, as part of our global business, we file numerous income tax returns in the U.S. federal, state and foreign jurisdictions. After the TCJA, our ability to obtain a tax benefit in certain countries that continue to have a lower statutory tax rates than the United States is dependent on our levels of taxable income in such foreign countries. We believe that a change in the statutory tax rate of any individual foreign country would not have a material effect on our financial statements given the geographic dispersion of our taxable income.
The amount of income taxes we pay is subject to audit by federal, state and foreign tax authorities, which may result in proposed assessments. The Company is subject to examination in the United States, various states and foreign jurisdiction for the tax years 2008 to 2018. We review our global tax positions on a quarterly basis. Based on these reviews, the results of discussions and resolutions of matters with certain tax authorities, tax rulings and court decisions and the expiration of statutes of limitations reserves for contingent tax liabilities are accrued or adjusted as necessary. For a discussion of risks related to these and other tax matters, please refer to “Item 1A. Risk Factors.”
We are routinely examined by various domestic and international taxing authorities. In connection with the Separation of Fortive from Danaher, we entered into the Agreements with Danaher, including a tax matters agreement. The tax matters agreement distinguishes between the treatment of tax matters for “Joint” filings compared to “separate” filings prior to the separation. “Joint” filings involve legal entities, such as those in the United States, that include operations from both Danaher and the Company. By contrast, “separate” filings involve certain entities (primarily outside of the United States), that exclusively include either Danaher’s or the Company’s operations, respectively. In accordance with the tax matters agreement, the Company is liable for and has indemnified Danaher against all income tax liabilities involving “separate” filings for the periods prior to the separation.
During 2018, the Company entered into a Tax Matters Agreement in connection with the split-off of the A&S Business. The Company remains liable for pre-disposition income tax liabilities related to the A&S Business.
Comparison of the Years Ended December 31, 2018, 2017 and 2016
Our effective tax rate for the years ended December 31, 2018, 2017 and 2016 was 14.8%, 17.6% and 26.7%, respectively.
Our effective tax rate for 2018 differs from the U.S. federal statutory rate of 21% due primarily to the effect of the TCJA U.S. federal permanent differences, the impact of credits and deductions provided by law, earnings outside the United States that are
indefinitely reinvested and taxed at rates lower than the U.S. federal statutory rate, and the effect of 2018 TCJA adjustments to the 2017 provisional estimates in accordance with SEC Staff Accounting Bulletin No. 118.
Our effective tax rate for 2017, including provisional estimates of the TCJA, differs from the U.S. federal statutory rate of 35.0% due primarily to net favorable impacts associated with the TCJA, our earnings outside the United States that are indefinitely reinvested and taxed at rates lower than the U.S. federal statutory rate, the impact of credits and deductions provided by law, state tax impacts, and favorable adjustments related to differences between estimates included in the 2016 provision and amounts calculated on the 2016 U.S. income tax return filed in October 2017.
Our effective tax rate for 2016 differs from the U.S. federal statutory rate of 35.0% due primarily to our earnings outside the United States that are indefinitely reinvested and taxed at rates lower than the U.S. federal statutory rate, and the impact of credits and deductions provided by law. The effective tax rate for 2016 includes benefits from the release of reserves resulting from expirations of statutes of limitations, primarily from periods prior to the Separation.
For the period prior to the Separation, current income tax liabilities related to entities which filed jointly with Danaher are assumed to be immediately settled with Danaher and are relieved through Former Parent’s investment. Income tax expense and other income tax related information contained in the consolidated and combined financial statements are presented as if we filed a separate tax return. The separate tax return method applies the accounting guidance for income taxes to the standalone financial statements as if we were a standalone taxpayer for the periods prior to the Separation. The calculation of our income taxes on a separate income tax return basis requires considerable judgment, estimates and allocations.
COMPREHENSIVE INCOME
Comprehensive income increased by $1.61 billion in 2018 as compared to 2017, due to net earnings that were higher by $1.87 billion and unfavorable changes in foreign currency translation adjustments of $264 million. Favorable pension benefit adjustments in 2018 were $4 million compared to favorable adjustments of $2 million in 2017.
Comprehensive income increased by $442 million in 2017 as compared to 2016, due primarily to favorable changes in foreign currency translation adjustments of $260 million and net earnings that were higher by $172 million. In addition, we recorded favorable pension benefit adjustments of $2 million in 2017 compared to unfavorable adjustments of $8 million in 2016.
INFLATION
The effect of inflation on our revenues and net earnings was not significant in any of the years ended December 31, 2018, 2017 or 2016.
FINANCIAL INSTRUMENTS AND RISK MANAGEMENT
We are exposed to market risk from changes in interest rates, foreign currency exchange rates, credit risk and commodity prices, each of which could impact our financial statements. We generally address our exposure to these risks through our normal operating and financing activities. In addition, our broad-based business activities help to reduce the impact that volatility in any particular area or related areas may have on our operating profit as a whole.
Interest Rate Risk
We manage interest cost using a mixture of fixed-rate and variable-rate debt. A change in interest rates on long-term debt impacts the fair value of our fixed-rate long-term debt but not our earnings or cash flows because the interest on such debt is fixed. Generally, the fair market value of fixed-rate debt will increase as interest rates fall and decrease as interest rates rise. As of December 31, 2018, an increase of 100 basis points in interest rates would have decreased the fair value of our fixed-rate long-term debt by approximately $145 million.
As of December 31, 2018, our variable-rate debt obligations consisted primarily of U.S. dollar and Euro-denominated commercial paper and term loan borrowings (refer to Note 10 to the Consolidated and Combined Financial Statements for information regarding our outstanding indebtedness as of December 31, 2018). As a result, our primary interest rate exposure results from changes in short-term interest rates. As these shorter duration obligations mature, we anticipate issuing additional short-term commercial paper obligations and term loans to refinance all or part of these borrowings. The annual effective rate associated with our outstanding U.S. dollar and Euro-denominated commercial paper and delayed-draw term loan, and Yen term loan for the year ended December 31, 2018 was approximately 2.98%, (0.10)%, 2.97% and 0.50%, respectively, and we recorded interest expense of $30.8 million on these variable-rate obligations. A hypothetical 10 basis points increase in market interest rates as of December 31, 2018 on our variable-rate debt obligations as of December 31, 2018 would have increased our interest expense by $2.5 million in 2018.
Foreign Currency Exchange Rate Risk
We face transactional exchange rate risk from transactions with customers in countries outside of the United States and from intercompany transactions between affiliates. Transactional exchange rate risk arises from the purchase and sale of goods and services in currencies other than our functional currency or the functional currency of an applicable subsidiary. We also face translational exchange rate risk related to the translation of financial statements of our foreign operations into U.S. dollars, our functional currency. Costs incurred and sales recorded by subsidiaries operating outside of the United States are translated into U.S. dollars using exchange rates effective during the respective period. As a result, we are exposed to movements in the exchange rates of various currencies against the U.S. dollar. The effect of a change in currency exchange rates on our net investment in international subsidiaries is reflected in the accumulated other comprehensive income (loss) component of equity. A 10% depreciation in major currencies relative to the U.S. dollar as of December 31, 2018 would have resulted in a reduction of stockholders’s equity of approximately $191 million.
Currency exchange rates positively impacted 2018 reported sales by 0.4% as compared to 2017, as the U.S. dollar was, on average, weaker against most major currencies during 2018 as compared to exchange rate levels during 2017. If the exchange rates in effect as of December 31, 2018 were to prevail throughout 2019, currency exchange rates would negatively impact 2019 estimated sales by approximately 1.2% relative to our performance in 2018. In general, additional weakening of the U.S. dollar against other major currencies would further positively impact our sales and results of operations on an overall basis and any strengthening of the U.S. dollar against other major currencies would adversely impact our sales and results of operations.
We have generally accepted the exposure to exchange rate movements without using derivative financial instruments to manage this risk. Both positive and negative movements in currency exchange rates against the U.S. dollar will therefore continue to affect the reported amount of sales, profit, and assets and liabilities in our consolidated and combined financial statements.
Credit Risk
We are exposed to potential credit losses in the event of nonperformance by counterparties to our financial instruments. Financial instruments that potentially subject us to credit risk consist of cash and highly-liquid investment grade cash equivalents, and receivables from customers. We place cash and cash equivalents with various high-quality financial institutions throughout the world and exposure is limited at any one institution. Although we typically do not obtain collateral or other security to secure these obligations, we regularly monitor the third party depository institutions that hold our cash and cash equivalents. We emphasize safety and liquidity of principal over yield on those funds. In addition, concentrations of credit risk arising from receivables from customers are limited due to the diversity of our customers. Our businesses perform credit evaluations of their customers’ financial conditions as appropriate and also obtain collateral or other security when appropriate.
Commodity Price Risk
For a discussion of risks relating to commodity prices, refer to “Item 1A. Risk Factors.”
LIQUIDITY AND CAPITAL RESOURCES
We assess our liquidity in terms of our ability to generate cash to fund our operating, investing and financing activities. We generate substantial cash from operating activities and believe that our operating cash flow and other sources of liquidity will be sufficient to allow us to continue to invest in existing businesses, consummate strategic acquisitions, make interest payments on our outstanding indebtedness, and manage our capital structure on a short and long-term basis. Refer also to Note 10 to our consolidated and combined financial statements for additional information.
2018 Financing and Capital Transactions
During 2018, we completed the following financing and capital transactions:
| • | On June 29, 2018, we issued 1,380,000 shares of 5.0% Mandatory Convertible Preferred Stock, Series A (“MCPS”) with a par value of $0.01 per share and liquidation preference of $1,000 per share, which included the exercise of an over-allotment option in full to purchase 180,000 shares. We received net $1.34 billion in proceeds from the issuance of the MCPS, excluding $43 million of issuance costs. We used the net proceeds from the issuance of MCPS to fund our acquisition activities and for general corporate purposes, including repayment of debt, working capital and capital expenditures. Each then outstanding share of MCPS will convert automatically on July 1, 2021 into between 10.9041 and 13.3575 common shares, subject to further anti-dilution adjustments. |
| • | On July 20, 2018, we prepaid $325 million of our outstanding U.S dollar variable interest rate term loan due in 2019, and on October 5, 2018, we prepaid the remaining $175 million of the outstanding balance. The prepayment penalties associated with these payments were immaterial. |
| • | On August 22, 2018, we entered into a credit facility agreement that provides for a 364-day delayed-draw term loan facility (“Delayed-Draw Term Loan”) with an aggregate principal amount of $1.75 billion. On September 5, 2018, we drew down the full $1.75 billion available under the Delayed-Draw Term Loan in order to fund, in part, the Accruent Acquisition. The Delayed-Draw Term Loan bears interest at a variable rate equal to the London inter-bank offered rate (“LIBOR”) plus a ratings based margin currently at 75 basis points. During 2018, the annual effective rate was approximately 2.97% per annum. The Delayed-Draw Term Loan is prepayable at our option, and we are not permitted to re-borrow once the term loan is repaid. On September 26, 2018 and November 21, 2018, we repaid $400 million of and $950 million of this loan, respectively. |
| • | On October 1, 2018, in connection with the debt exchange in the split-off of the A&S Business, we retired $244.7 million of our 1.80% senior unsecured notes due in 2019. |
| • | On November 30, 2018 we entered into an amended and restated agreement (“the Credit Agreement”) extending the availability period of the Revolving Credit Facility to November 30, 2023 and increased the facility to $2.0 billion. The Revolving Credit Facility is subject to a one year extension option at our request and with the consent of the lenders. The Credit Agreement also contains an option permitting us to request an increase in the amounts available under the Credit Agreement of up to an aggregate additional $1.0 billion. |
2017 Financing Transactions
During 2017, we completed the following financing transactions:
| • | On June 12, 2017, we filed a shelf registration statement on Form S-3 with the SEC (the “Shelf Registration Statement”) that registers an indeterminate amount of debt securities, common stock, preferred stock, warrants, depositary shares, purchase contracts and units that may be issued in the future in one or more offerings. Unless otherwise specified in the corresponding prospectus supplement, we expect to use net proceeds realized from future securities issuances off the Shelf Registration Statement for general corporate purposes, including without limitation repayment or refinancing of debt or other corporate obligations, acquisitions, capital expenditures, dividends and working capital. |
| • | On August 24, 2017, we entered into a term loan agreement that provides for a five-year ¥13.8 billion senior unsecured term facility (“Yen Term Loan”) that matures on August 24, 2022. We borrowed the entire ¥13.8 billion available under this facility on August 28, 2017, which yielded net proceeds of approximately $126 million. The Yen Term Loan bears interest at a rate equal to LIBOR plus 50 basis points, provided however that LIBOR may not be less than zero for the purposes of the Yen Term Loan. As of December 31, 2018, borrowings under the Yen Term Loan bear an interest rate of 0.50% per annum and the annual effective rate was approximately 0.50% during the year ended December 31, 2018. The Yen Term Loan is pre-payable at our option, and the terms and conditions, including covenants, applicable to the Yen Term Loan are substantially similar to those applicable to the senior unsecured revolving credit facility (the “Revolving Credit Facility”) as described in Note 10 of the Consolidated and Combined Financial Statements. |
2016 Financing Transactions
During 2016, we completed the following financing transactions:
| • | Entered into a credit agreement with a syndicate of banks providing for a three-year $500 million senior term facility that expires on June 16, 2019 (the “Term Facility”) and a five-year $1.5 billion Revolving Credit Facility that expires on June 16, 2021. We borrowed the entire $500 million of loans under the Term Facility; |
| • | Completed the private placement of $2.5 billion of senior unsecured notes in multiple series with maturity dates ranging from June 15, 2019 to June 15, 2046 (collectively, the “Private Notes”); and |
| • | Established U.S. dollar and Euro-denominated commercial paper programs (collectively the “Commercial Paper Programs”) supported by the Revolving Credit Facility. |
Approximately $3.0 billion of the net proceeds of these financings activities was paid to Danaher in June 2016 as a cash dividend in connection with the Separation. Refer to Note 10 of the Consolidated and Combined Financial Statements for more information related to our long-term indebtedness.
In connection with the issuance of the Private Notes, we entered into a registration rights agreement, pursuant to which we were obligated to use commercially reasonable efforts to file with the SEC, and cause to be declared effective, a registration statement with respect to an offer to exchange each series of Private Notes for registered notes (“Registered Notes”) with substantially identical terms (“Exchange Offer”). And, on May 5, 2017 we filed a Form S-4 with the SEC (the “Registration Statement”), which Registration Statement was declared effective on May 17, 2017. On May 17, 2017, we launched the Exchange Offer, which expired on June 14, 2017. All Private Notes were tendered and exchanged for Registered Notes in the Exchange Offer.
Overview of Cash Flows and Liquidity
Following is an overview of our cash flows and liquidity:
| Year Ended December 31, | |||||||||||
| ($ in millions) | 2018 | 2017 | 2016 | ||||||||
| Total operating cash provided by continuing operations | $ | 1,201.3 | $ | 1,020.1 | $ | 982.4 | |||||
| Cash paid for acquisitions, net of cash received | $ | (2,815.1 | ) | $ | (1,556.6 | ) | $ | (190.1 | ) | ||
| Payments for additions to property, plant and equipment | (112.3 | ) | (111.1 | ) | (110.1 | ) | |||||
| Proceeds from sale of property | — | 21.5 | 9.0 | ||||||||
| All other investing activities | (42.1 | ) | 1.5 | — | |||||||
| Total investing cash used in continuing operations | $ | (2,969.5 | ) | $ | (1,644.7 | ) | $ | (291.2 | ) | ||
| Net (repayments of) proceeds from borrowings (maturities of 90 days or less) | $ | (266.1 | ) | $ | 556.2 | $ | 373.8 | ||||
| Proceeds from borrowings (maturities greater than 90 days) | 1,750.0 | 125.9 | 2,978.1 | ||||||||
| Repayment of borrowings (maturities greater than 90 days) | (1,850.0 | ) | — | — | |||||||
| Proceeds from issuance of mandatory convertible preferred stock, net of $43 million of issuance costs | 1,337.4 | — | — | ||||||||
| Payment of common stock cash dividend to shareholders | (96.6 | ) | (97.2 | ) | (48.4 | ) | |||||
| Payment of mandatory convertible preferred stock cash dividend to shareholders | (34.9 | ) | — | — | |||||||
| Payment of cash dividend to former Parent | — | — | (3,000.0 | ) | |||||||
| Net transfers to former Parent | — | — | (301.4 | ) | |||||||
| Other financing activities | 39.3 | 13.4 | 0.3 | ||||||||
| Total financing cash provided by continuing operations | $ | 879.1 | $ | 598.3 | $ | 2.4 |
Operating Activities
Continuing operations cash flows from operating activities can fluctuate significantly from period-to-period as working capital needs and the timing of payments for income taxes, restructuring activities, pension funding and other items impact reported cash flows.
Operating cash flows from continuing operations were approximately $1.20 billion in 2018, an increase of $181 million, or approximately 18%, as compared to 2017. This year-over-year change in operating cash flows from continuing operations was primarily attributable to the following factors:
| • | 2018 operating cash flows benefited from higher net earnings from continuing operations as compared to 2017. Net earnings for 2018 benefited from a year-over-year increase in operating profits of $35 million, partially offset by a year-over-year increase in interest expense of $8 million primarily associated with our financing activities, and the 2017 impacts of a non-cash acquisition related gain of $15 million and a gain on the sale of property of $8 million. The year-over-year increase in operating profit was partially offset by higher depreciation and amortization expenses of $103 million largely attributable to our recently acquired businesses. Depreciation and amortization are noncash expenses that decrease earnings without a corresponding impact to operating cash flows. |
| • | On a year over year basis, net earnings from continuing operations was $57.8 million lower than 2017 due to the impact of the TCJA, which was enacted in 2017. |
| • | The aggregate of accounts receivable, inventories and trade accounts payable used $103 million of operating cash flows during 2018 compared to using $20 million of cash during 2017. The amount of cash flow generated from or used by the aggregate of accounts receivable, inventories and trade accounts payable depends upon how effectively we manage the cash conversion cycle, which effectively represents the number of days that elapse from the day we pay for the purchase of raw materials and components to the collection of cash from our customers and can be significantly impacted by the timing of collections and payments in a period. |
| • | The aggregate of prepaid expenses and other assets and accrued expenses and other liabilities provided $66 million of cash in 2018 as compared to providing $36 million in 2017. The timing of cash tax payments and refunds drove the majority of this change. |
Operating cash flows from continuing operations were approximately $1.02 billion in 2017, an increase of $38 million or approximately 4%, as compared to 2016. This year-over-year change in operating cash flows was primarily attributable to the following factors:
| • | 2017 operating cash flows benefited from higher net earnings from continuing operations as compared to 2016. Net earnings from continuing operations for 2017 benefited from a year-over-year increase in operating profits of $81 million, a $15 million non-cash gain from an acquisition and an $8 million gain on the sale of property. These were partially offset by a year-over-year increase in interest expense, net and other non-operating expenses of $42 million primarily associated with debt issued in June 2016 in connection with the Separation. The year-over-year increase in operating profit was not significantly impacted by changes in depreciation and amortization, which are noncash expenses that decrease earnings without a corresponding impact to operating cash flows. |
| • | The aggregate of accounts receivable, inventories and trade accounts payable used $20 million of operating cash flows during 2017 compared to providing $15 million of cash during 2016. The amount of cash flow generated from or used by the aggregate of accounts receivable, inventories and trade accounts payable depends upon how effectively we manage the cash conversion cycle, which effectively represents the number of days that elapse from the day we pay for the purchase of raw materials and components to the collection of cash from our customers and can be significantly impacted by the timing of collections and payments in a period. |
| • | Net earnings included a benefit of $70 million representing our provisional estimate of the impacts of the TCJA. This benefit did not impact cash flows in 2017. |
Investing Activities
Cash flows relating to investing activities consist primarily of cash used for acquisitions and capital expenditures. Net cash used in investing activities from continuing operations was approximately $2.97 billion during 2018 compared to approximately $1.64 billion and $291 million of net cash used in 2017 and 2016, respectively. For a discussion of our acquisitions refer to “—Overview.”
Capital expenditures are made primarily for increasing capacity, replacing equipment, supporting product development initiatives, improving information technology systems and purchase of equipment that is used in operating-type lease arrangements with customers. Capital expenditures totaled $112 million in 2018, $111 million in 2017 and $110 million in 2016. The change in capital expenditures is due primarily to timing of investments and, in 2017, increased year-over-year expenditures on equipment, which contribute to our recurring revenue base. Excluding the impact of our pending acquisition, we expect capital spending to be between approximately $120 million and $130 million in 2019, though actual expenditures will ultimately depend on business conditions.
Financing Activities and Indebtedness
Cash flows from financing activities consist primarily of cash flows associated with the issuance and repayments of debt and commercial paper, the issuance of shares of 5.0% Mandatory Convertible Preferred Stock, Series A (“MCPS”) and payments of quarterly cash dividends to shareholders. Financing activities from continuing operations generated cash of $879 million in 2018 compared to $598 million of cash provided in 2017 and $2 million provided in 2016. In 2018, we received proceeds from the issuance of our MCPS of $1.34 billion, received proceeds from borrowings with maturities greater than 90 days of $1.75 billion, repaid net $266.1 million of commercial paper under the Commercial Paper Programs and borrowings with maturities greater than 90 days of $1.85 billion, and paid $132 million of cash dividends to shareholders.
Refer to —Liquidity and Capital Resources section above for a description of our financing activities in 2018, 2017 and 2016.
We generally expect to satisfy any short-term liquidity needs that are not met through operating cash flows and available cash primarily through issuances of commercial paper under the Commercial Paper Programs. Credit support for the Commercial Paper Programs is provided by the Revolving Credit Facility. We classified our borrowings outstanding under the Commercial Paper Programs as long-term debt in the accompanying Consolidated Balance Sheet as of December 31, 2018, as we have the intent and ability, as supported by availability under the Revolving Credit Facility, to refinance these borrowings for at least one year from the balance sheet date. As commercial paper obligations mature, we may issue additional short-term commercial paper obligations to refinance all or part of these borrowings.
The carrying value of total debt outstanding as of December 31, 2018 was approximately $3.4 billion. We had $2.0 billion available under the Revolving Credit Facility as of December 31, 2018. Of this amount, approximately $660 million was being used to backstop outstanding U.S. and Euro commercial paper balances. Accordingly, we had the ability to incur an additional $1.34 billion of indebtedness under the Revolving Credit Facility as of December 31, 2018. Refer to Note 10 to the Consolidated and Combined Financial Statements for information regarding our financing activities and indebtedness.
The availability of the Revolving Credit Facility as a standby liquidity facility to repay maturing commercial paper is an important factor in maintaining the existing credit ratings of the Commercial Paper Programs. We expect to limit any borrowings under the Revolving Credit Facility to amounts that would leave sufficient credit available under the facility to allow us to borrow, if needed, to repay all of the outstanding commercial paper as it matures.
As of December 31, 2018, commercial paper outstanding under the U.S. dollar-denominated commercial paper program had an annual effective rate of 2.98% and a weighted average remaining maturity of approximately 18 days. As of December 31, 2018, commercial paper outstanding under the Euro-denominated commercial paper program had an annual effective rate of (0.10)% and a weighted average remaining maturity of approximately 58 days.
In 2017, we received net proceeds from the issuance of commercial paper under the Commercial Paper Programs of $556 million, received proceeds from borrowings of $126 million and paid $97 million of cash dividends to shareholders.
In 2016, we incurred approximately $3.4 billion of indebtedness offset by $3.3 billion of payments and net transfers to Former Parent. We no longer make any net transfers to Former Parent as a result of the Separation.
Dividends
On November 8, 2018, we declared a regular quarterly dividend of $0.07 per common share paid on December 28, 2018 to holders of record on November 30, 2018. In addition, Fortive announced that its Board of Directors declared a regular quarterly cash dividend of $12.50 per share of its 5.00% Mandatory Convertible Preferred Stock, Series A, payable on January 2, 2019 to preferred stockholders of record on December 15, 2018. The dividend to preferred shareholders was paid on December 31, 2018.
Aggregate cash payments for the dividends paid to shareholders during the year ended December 31, 2018 were $132 million and were recorded as dividends to shareholders in the Consolidated and Combined Statements of Changes in Equity and the Consolidated and Combined Statements of Cash Flows.
On January 29, 2019 we declared a regular quarterly cash dividend of $0.07 per share payable on March 29, 2019 to common stockholders of record on February 22, 2019 and a regular quarterly cash dividend of $12.50 per share on our MCPS payable on April 1, 2019 to preferred stockholders of record on March 15, 2019.
Cash and Cash Requirements
As of December 31, 2018, we held approximately $1.18 billion of cash and cash equivalents that were invested in highly liquid investment-grade instruments with a maturity of 90 days or less with an annual effective rate of approximately 1.0%. Substantially all of the cash was held outside of the United States.
We have cash requirements to support working capital needs, capital expenditures and acquisitions, pay interest and service debt, pay taxes and any related interest or penalties, fund our restructuring activities and pension plans as required, pay dividends to shareholders and support other business needs or objectives. With respect to our cash requirements, we generally intend to use available cash and internally generated funds to meet these cash requirements, but in the event that additional liquidity is required, particularly in connection with acquisitions, we may also borrow under our commercial paper programs or credit facilities, enter into new credit facilities and either borrow directly thereunder or use such credit facilities to backstop additional borrowing capacity under our commercial paper programs and/or access the capital markets. We also may from time to time access the capital markets, including to take advantage of favorable interest rate environments or other market conditions.
The TCJA that was enacted in December 2017 is materially improving our U.S. liquidity through lower corporate tax rates and enhanced cash repatriation. During the year ended December 31, 2018, we repatriated $275 million in connection with the TCJA and these repatriations did not result in any foreign remittance taxes.
Conversely, we have made an assertion regarding the amount of earnings that we do not intend to repatriate due to local working capital needs, local law restrictions, high foreign remittance costs, previous investments in physical assets and acquisitions, or future growth needs. Such earnings are intended for indefinite foreign reinvestment and no provision for non-U.S. income taxes has been made. The amount of income taxes that may be applicable to such earnings is not readily determinable given the unknown duration of local law restrictions as applicable to such earnings, unknown changes in foreign tax law that may occur during the restriction periods, and the various alternatives we could employ if we repatriated these earnings. The cash that our foreign subsidiaries hold for indefinite reinvestment is generally used to finance foreign operations and investments, including acquisitions. We expect the TCJA to have a favorable impact in our future ability to engage in acquisition activities.
As of December 31, 2018, we believe that we have sufficient liquidity to satisfy our cash needs, including our cash needs in the United States.
During 2018, we contributed $10 million to our non-U.S. defined benefit pension plans. During 2019, our cash contribution requirements for our non-U.S. defined benefit pension plans are expected to be approximately $8 million. We do not expect to make contributions to the U.S. plan during 2019. The ultimate amounts to be contributed depend upon, among other things, legal requirements, underlying asset returns, the plan’s funded status the anticipated tax deductibility of the contribution, local practices, market conditions, interest rates and other factors.
Contractual Obligations
The following table sets forth, by period due or year of expected expiration, as applicable, a summary of our contractual obligations as of December 31, 2018 under (1) long-term debt obligations, (2) leases, (3) purchase obligations and (4) other long-term liabilities reflected on our balance sheet under GAAP. Certain of our acquisitions may involve the potential payment of contingent consideration. The table below does not reflect any such obligations, as the timing and amounts of any such payments are uncertain. Refer to “—Off-Balance Sheet Arrangements” for a discussion of other contractual obligations that are not reflected in the table below.
| ($ in millions) | Total | Less than one year | 1-3 years | 3-5 years | More than 5 years | ||||||||||||||
| Debt and leases: | |||||||||||||||||||
| Long-term debt obligations (a)(b) | $ | 3,444.3 | $ | 1,118.6 | $ | 875.7 | $ | — | $ | 1,450.0 | |||||||||
| Capital lease obligations(b) | 3.0 | 0.1 | 0.9 | 0.5 | 1.5 | ||||||||||||||
| Long-term debt | 3,447.3 | 1,118.7 | 876.6 | 0.5 | 1,451.5 | ||||||||||||||
| Interest payments on long-term debt and capital lease obligations (c) | 905.4 | 70.3 | 130.0 | 104.2 | 600.9 | ||||||||||||||
| Operating lease obligations (d) | 181.4 | 54.2 | 73.6 | 37.5 | 16.1 | ||||||||||||||
| Other: | |||||||||||||||||||
| Purchase obligations (e) | 335.7 | 306.2 | 26.1 | 3.4 | — | ||||||||||||||
| Other long-term liabilities reflected on the balance sheet under GAAP (f)(g) | 1,125.9 | — | 118.3 | 85.0 | 922.6 | ||||||||||||||
| Total | $ | 5,995.7 | $ | 1,549.4 | $ | 1,224.6 | $ | 230.6 | $ | 2,991.1 | |||||||||
| (a) As described in Note 10 to the Consolidated and Combined Financial Statements. | |||||||||||||||||||
| (b) Amounts do not include interest payments. Interest on long-term debt and capital lease obligations is reflected in a separate line in the table. | |||||||||||||||||||
| (c) Interest payments on long-term debt are projected for future periods using the interest rates in effect as of December 31, 2018. Certain of these projected interest payments may differ in the future based on changes in market interest rates. | |||||||||||||||||||
| (d) Includes future minimum lease payments for operating leases having initial or remaining noncancelable lease terms in excess of one year. Certain leases require us to pay real estate taxes, insurance, maintenance and other operating expenses associated with the leased premises. These future costs are not included in the schedule above. | |||||||||||||||||||
| (e) Consist of agreements to purchase goods or services that are enforceable and legally binding on us and that specify all significant terms, including fixed or minimum quantities to be purchased, fixed, minimum or variable price provisions and the approximate timing of the transaction. | |||||||||||||||||||
| (f) Primarily consist of obligations under product service and warranty policies and allowances, performance and operating cost guarantees, estimated environmental remediation costs, self-insurance and litigation claims, post-retirement benefits, pension benefit obligations, net tax liabilities and deferred compensation obligations. The timing of cash flows associated with these obligations is based upon management’s estimates over the terms of these arrangements and is largely based upon historical experience. | |||||||||||||||||||
| (g) Includes non-contractual obligations of $149 million of noncurrent gross unrecognized tax benefits. However, the timing of these liabilities is uncertain, and therefore, they have been included in the “more than 5 years” column. Also includes our obligation under the TCJA for the transition tax on cumulative foreign earnings and profits, which we expect to pay over eight years. Refer to Note 13 to the Consolidated and Combined Financial Statements for additional information on unrecognized tax benefits. |
Off-Balance Sheet Arrangements
The following table sets forth, by period due or year of expected expiration, as applicable, a summary of our off-balance sheet commitments as of December 31, 2018:
| Amount of Commitment Expiration per Period | |||||||||||||||||||
| ($ in millions) | Total | Less Than One Year | 1-3 Years | 4-5 Years | More Than 5 Years | ||||||||||||||
| Guarantees | $ | 138.0 | $ | 74.3 | $ | 23.5 | $ | 6.2 | $ | 34.0 |
Guarantees consist primarily of outstanding standby letters of credit, bank guarantees and performance and bid bonds. These guarantees have been provided in connection with certain arrangements with vendors, customers, financing counterparties and governmental entities to secure our obligations and/or performance requirements related to specific transactions.
Other Off-Balance Sheet Arrangements
We have, from time to time, divested certain of our businesses and assets. In connection with these divestitures, we often provide representations, warranties and/or indemnities to cover various risks and unknown liabilities, such as claims for damages arising out of the use of products or relating to intellectual property matters, commercial disputes, environmental matters or tax matters. We have not included any such items in the contractual obligations table above because they relate to unknown conditions and we cannot reasonably estimate the potential liabilities from such matters, but we do not believe it is reasonably possible that any such liability will have a material effect on our financial statements. In addition, as a result of these divestitures, as well as restructuring activities, certain properties leased by us have been sublet to third parties. In the event any of these third parties vacate any of these premises, we would be legally obligated under master lease arrangements. We believe the financial risk of default by such sub-lessors is individually and in the aggregate not material to our financial statements.
In the normal course of business, we periodically enter into agreements that require us to indemnify customers, suppliers or other business partners for specific risks, such as claims for injury or property damage arising out of our products or services or claims alleging that our products, services or software infringe third party intellectual property. We have not included any such indemnification provisions in the contractual obligations table above. Historically, we have not experienced significant losses on these types of indemnification obligations.
Our Restated Certificate of Incorporation requires us to indemnify to the full extent authorized or permitted by law any person made, or threatened to be made a party to any action or proceeding by reason of his or her service as a director or officer of the Company, or by reason of serving at the request of the Company as a director or officer of any other entity, subject to limited exceptions. Our Amended and Restated Bylaws provide for similar indemnification rights. In addition, we have executed with each of our directors and executive officers an indemnification agreement which provides for substantially similar indemnification rights and under which we have agreed to pay expenses in advance of the final disposition of any such indemnifiable proceeding. While we maintain insurance for this type of liability, a significant deductible applies to this coverage and any such liability could exceed the amount of the insurance coverage.
Legal Proceedings
Please refer to Note 16 to the Consolidated and Combined Financial Statements for information regarding legal proceedings and contingencies, and for a discussion of risks related to legal proceedings and contingencies, refer to “Item 1A. Risk Factors.”
CRITICAL ACCOUNTING ESTIMATES
Management’s discussion and analysis of our financial condition and results of operations is based upon our consolidated and combined financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base these estimates and judgments on historical experience, the current economic environment and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ materially from these estimates and judgments.
We believe the following accounting estimates are most critical to an understanding of our financial statements. Estimates are considered to be critical if they meet both of the following criteria: (1) the estimate requires assumptions about material matters that are uncertain at the time the estimate is made, and (2) material changes in the estimate are reasonably likely from period to period. For a detailed discussion on the application of these and other accounting estimates, refer to Note 2 to the Consolidated and Combined Financial Statements.
Accounts Receivable: We maintain allowances for doubtful accounts to reflect probable credit losses inherent in our portfolio of receivables. Determination of the allowances requires us to exercise judgment about the timing, frequency and severity of credit losses that could materially affect the allowances for doubtful accounts and, therefore, net income. The allowances for doubtful accounts represent management’s best estimate of the credit losses expected from our trade accounts, contract and financing receivable portfolios. The level of the allowances is based on many quantitative and qualitative factors including historical loss experience by receivable type, portfolio duration, delinquency trends, economic conditions and credit risk quality. We regularly perform detailed reviews of our accounts receivable portfolio to determine if an impairment has occurred and to assess the adequacy of the allowances. If the financial condition of our customers were to deteriorate with a severity,
frequency and/or timing different from our assumptions, additional allowances would be required and our financial statements would be adversely impacted.
Inventories: We record inventory at the lower of cost or net realizable value, which is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. We estimate the net realizable value of our inventory based on assumptions of future demand and related pricing. Estimating the net realizable value of inventory is inherently uncertain because levels of demand, technological advances and pricing competition in many of our markets can fluctuate significantly from period to period due to circumstances beyond our control. If actual market conditions are less favorable than those we projected, we could be required to reduce the value of our inventory, which would adversely impact our financial statements. Refer to Note 5 to the Consolidated and Combined Financial Statements.
Acquired Intangibles: Our business acquisitions typically result in the recognition of goodwill, in-process R&D and other intangible assets, which affect the amount of future period amortization expense and possible impairment charges that we may incur. Refer to Notes 2, 3 and 7 to the Consolidated and Combined Financial Statements for a description of our policies relating to goodwill, acquired intangibles and acquisitions.
In performing our goodwill impairment testing, we estimate the fair value of our reporting units primarily using a market based approach. We estimate fair value based on multiples of earnings before interest, taxes, depreciation and amortization (“EBITDA”) determined by current trading market multiples of earnings for companies operating in businesses similar to each of our reporting units, in addition to recent market available sale transactions of comparable businesses. In evaluating the estimates derived by the market based approach, we make judgments about the relevance and reliability of the multiples by considering factors unique to our reporting units, including operating results, business plans, economic projections, anticipated future cash flows, and transactions and marketplace data as well as judgments about the comparability of the market proxies selected. In certain circumstances we also evaluate other factors including results of the estimated fair value utilizing a discounted cash flow analysis (i.e., an income approach), market positions of the businesses, comparability of market sales transactions and financial and operating performance in order to validate the results of the market approach. The discounted cash flow model requires judgmental assumptions about projected revenue growth, future operating margins, discount rates and terminal values. There are inherent uncertainties related to these assumptions and management’s judgment in applying them to the analysis of goodwill impairment.
In 2018, we had thirteen reporting units for goodwill impairment testing. Reporting units resulting from recent acquisitions generally present the highest risk of impairment. We believe the impairment risk associated with these reporting units generally decreases as we integrate these businesses and better position them for potential future earnings growth. The carrying value of the goodwill included in each individual reporting unit ranges from $15 million to $1.7 billion. Our annual goodwill impairment analysis in 2018 indicated that in all instances, the fair values of our reporting units exceeded their carrying values and consequently did not result in an impairment charge. The excess of the estimated fair value over carrying value (expressed as a percentage of carrying value for the respective reporting unit) for each of our reporting units as of the annual testing date ranged from approximately 0% to approximately 900%. In order to evaluate the sensitivity of the fair value calculations used in the goodwill impairment test, we applied a hypothetical 10% decrease to the fair values of each reporting unit and compared those hypothetical values to the reporting unit carrying values. Based on this hypothetical 10% decrease, the excess of the estimated fair value over carrying value (expressed as a percentage of carrying value for the respective reporting unit) for each of our reporting units ranged from approximately -10% to approximately 800%. After applying the hypothetical 10% decrease, two reporting units, representing recently acquired businesses, had hypothetical fair values below their carrying value. We evaluated other factors relating to the fair value of these reporting units including, as applicable, results of the estimated fair value using an income approach, market positions of the businesses, comparability of market sales transactions and financial and operating performance, and we concluded no impairment charge was required.
We review identified intangible assets for impairment whenever events or changes in circumstances indicate that the related carrying amounts may not be recoverable. Determining whether an impairment loss occurred requires a comparison of the carrying amount to the sum of undiscounted cash flows expected to be generated by the asset. We also test intangible assets with indefinite lives at least annually for impairment. These analyses require management to make judgments and estimates about future revenues, expenses, market conditions and discount rates related to these assets.
If actual results are not consistent with management’s estimates and assumptions, goodwill and other intangible assets may be overstated and a charge would need to be taken against net earnings which would adversely affect our financial statements.
Contingent Liabilities: As discussed in Note 16 to the Consolidated and Combined Financial Statements, we are, from time to time, subject to a variety of litigation and similar contingent liabilities incidental to our business (or the business operations of previously owned entities). We recognize a liability for any contingency that is known or probable of occurrence and reasonably estimable. These assessments require judgments concerning matters such as litigation developments and outcomes,
the anticipated outcome of negotiations, the number of future claims and the cost of both pending and future claims. In addition, because most contingencies are resolved over long periods of time, liabilities may change in the future due to various factors, including those discussed in Note 16 to the Consolidated and Combined Financial Statements. If the reserves we established with respect to these contingent liabilities are inadequate, we would be required to incur an expense equal to the amount of the loss incurred in excess of the reserves, which would adversely affect our financial statements.
Revenue Recognition: We derive revenues from the sale of products and services. On January 1, 2018, we adopted Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (Topic 606), which superseded nearly all existing revenue recognition guidance. Refer to Note 12 to the Consolidated and Combined Financial Statements for additional information on our adoption of this ASU.
If our judgments regarding revenue recognition prove incorrect, our reported revenues in particular periods may be adversely affected. Historically, our estimates of revenue have been materially correct.
Stock-Based Compensation: For a description of our stock-based compensation accounting practices, refer to Note 17 to our Consolidated and Combined Financial Statements. Determining the appropriate fair value model and calculating the fair value of stock-based payment awards require subjective assumptions, including the expected life of the awards, stock price volatility and expected forfeiture rate. Given our limited trading history following the Separation, stock price volatility used to calculate the fair value of stock-based payment awards in the post-Separation period was estimated based on an average historical stock price volatility of a group of peer companies. The assumptions used in calculating the fair value of stock-based payment awards represent our best estimates, but these estimates involve inherent uncertainties and the application of judgment. If actual results are not consistent with our assumptions and estimates, our equity-based compensation expense could be materially different in the future.
Pensions: For a description of our pension accounting practices, refer to Note 11 to the Consolidated and Combined Financial Statements. Certain of our non-U.S. employees participate in noncontributory defined benefit pension plans. Calculations of the amount of pension costs and obligations depend on the assumptions used in the actuarial valuations, including assumptions regarding discount rates, expected return on plan assets, rates of salary increases, health care cost trend rates, mortality rates, and other factors. If the assumptions used in calculating pension and other post-retirement benefits costs and obligations are incorrect or if the factors underlying the assumptions change (as a result of differences in actual experience, changes in key economic indicators or other factors), our financial statements could be materially affected. A 50 basis point reduction in the discount rates used for the plans during 2018 would have increased the net obligation by $21 million ($17 million on an after tax basis) from the amounts recorded in the financial statements as of December 31, 2018.
Our plan assets consist of various insurance contracts, equity and debt securities as determined by the administrator of each plan. The estimated long-term rate of return for the plans was determined on a plan by plan basis based on the nature of the plan assets and ranged from 1.75% to 6.0%. If the expected long-term rate of return on plan assets during 2018 was reduced by 50 basis points, pension expense in 2018 would have increased by $1.0 million ($0.8 million on an after-tax basis).
Income Taxes: For a description of our income tax accounting policies, refer to Note 2 and Note 13 to the Consolidated and Combined Financial Statements.
We establish valuation allowances for our deferred tax assets if it is more likely than not that some or all of the deferred tax asset will not be realized. As such, we make judgments and estimates regarding: (1) the timing and amount of the reversal of taxable temporary differences, (2) expected future taxable income, and (3) the impact of tax planning strategies. Future changes to tax rates would also impact the amounts of deferred tax assets and liabilities and could have an adverse impact on our financial statements.
We recognize tax benefits from uncertain tax positions only if, in our assessment, it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Judgment is required in evaluating tax positions and determining income tax provisions. We re-evaluate the technical merits of our tax positions and may recognize an uncertain tax benefit in certain circumstances, including when: (i) a tax audit is completed; (ii) applicable tax laws change, including a tax case ruling or legislative guidance; or (iii) the applicable statute of limitations expires.
In addition, certain of our tax returns are currently subject to review by tax authorities (see “-Results of Operations - Income Taxes” and Note 13 to the Consolidated and Combined Financial Statements). We believe the positions taken in these returns are in accordance with the relevant tax laws. However, the outcome of these audits is uncertain and could result in us being
required to record charges for prior year tax obligations which could have a material adverse impact on our financial statements, including our effective tax rate.
An increase in our 2018 effective tax rate of 1.0% would have resulted in an additional income tax provision for the fiscal year ended December 31, 2018 of $11 million.
Corporate Allocations: Prior to the Separation we operated as part of Danaher and not as a stand-alone company. Accordingly, we had been allocated certain shared costs which are reflected as expenses in the combined financial statements for the period prior to the Separation. We consider the allocation methodologies used to be reasonable and appropriate reflections of the related expenses attributable to the Company for purposes of the combined financial statements. Refer to Note 20 to the Consolidated and Combined Financial Statements for a description of the pre-Separation allocations from Danaher and related party transactions.
NEW ACCOUNTING STANDARDS
For a discussion of new accounting standards relevant to our businesses, refer to Note 2 to the Consolidated and Combined Financial Statements.
SEPARATION FROM DANAHER
In connection with the Separation, on July 1, 2016, we entered into agreements that govern the Separation and the relationships between the parties following the Separation, including an employee matters agreement, a tax matters agreement, an intellectual property matters agreement, a Danaher Business System license agreement and a transition services agreement (collectively the “Agreements”).
Prior to the Separation on July 1, 2016, we were dependent upon Danaher for all of our working capital and financing requirements under Danaher’s centralized approach to cash management and financing of operations of its subsidiaries. With the exception of cash, cash equivalents and borrowings clearly associated with Fortive and related to the Separation, including the financial transactions described above, financial transactions relating to our business operations during the period prior to the Separation were accounted for through the Former Parent’s investment, net (“Former Parent’s Investment”) account. Accordingly, none of our Former Parent’s cash, cash equivalents or debt at the corporate level was assigned to us in the financial statements for the periods prior to the Separation. As a result of the Separation, we no longer participate in Danaher’s cash management and financing operations.
The accompanying consolidated and combined financial statements present our historical financial position, results of operations, changes in equity and cash flows in accordance with GAAP. The combined financial statements for the period prior to the Separation were derived from Danaher’s consolidated financial statements and accounting records and prepared in accordance with GAAP for the preparation of carved-out combined financial statements. Through the date of the Separation, all revenues and costs as well as assets and liabilities directly associated with Fortive have been included in the combined financial statements. Prior to the Separation, the combined financial statements also included allocations of certain general, administrative, sales and marketing expenses and cost of sales from Danaher’s corporate office and from other Danaher businesses to the Company and allocations of related assets, liabilities, and the Former Parent’s investment, as applicable. The allocations were determined on a reasonable basis; however, the amounts are not necessarily representative of the amounts that would have been reflected in the financial statements had the Company been an entity that operated independently of Danaher during the applicable periods. Related party allocations prior to the Separation, including the method for such allocation, are discussed further in Note 20 to the Consolidated and Combined Financial Statements.
Following the Separation, the consolidated financial statements include the accounts of Fortive and those of our wholly-owned subsidiaries and no longer include any allocations from Danaher.
Prior to the Separation, these consolidated and combined financial statements may not be indicative of our results had we been a separate stand-alone entity throughout the periods presented, nor are the results stated herein indicative of what our financial position, results of operations and cash flows may be in the future.
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