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
Executive Overview of the Business
The Company is primarily engaged in the design, manufacture and sale of quality electrical and electronic products for a broad range of non-residential and residential construction, industrial and utility applications. Products are either sourced complete, manufactured or assembled by subsidiaries in the United States, Canada, Puerto Rico, China, Mexico, the UK, Brazil, Australia, Spain and Ireland. The Company also participates in joint ventures in Taiwan, Hong Kong and the Philippines, and maintains offices in Singapore, Italy, China, India, Mexico, South Korea, Chile, and countries in the Middle East. The Company employed approximately 18,800 individuals worldwide as of December 31, 2019.
The Company’s reporting segments consist of the Electrical segment and the Power segment. Results for 2019, 2018 and 2017 by segment are included under “Segment Results” within this Management’s Discussion and Analysis.
The Company's long-term strategy is to serve its customers with reliable and innovative electrical and related infrastructure solutions with desired brands, high-quality service, delivered through a competitive cost structure; to complement organic revenue growth with acquisitions that enhance its product offerings; and to allocate capital effectively to create shareholder value.
Our strategy to complement organic revenue growth with acquisitions focuses on acquiring assets that extend our capabilities, expand our product offerings, and present opportunities to compete in core, adjacent or complementary markets. Our acquisition strategy also provides the opportunity to advance our revenue growth objectives during periods of weakness or inconsistency in our end-markets.
Our strategy to deliver products through a competitive cost structure has resulted in ongoing restructuring and related activities. Our restructuring and related efforts include the consolidation of manufacturing and distribution facilities, and workforce actions, as well as streamlining and consolidating our back-office functions. The primary objectives of our restructuring and related activities are to optimize our manufacturing footprint, cost structure, and effectiveness and efficiency of our workforce.
Productivity improvement also continues to be a key area of focus for the Company and efforts to drive productivity complement our restructuring and related activities to minimize the impact of rising material costs and other cost inflation. Material costs are approximately sixty percent of our cost of goods sold therefore volatility in this area can significantly affect profitability. Our goal is to have pricing and productivity programs that offset material and other inflationary cost increases as well as pay for investments in key growth areas.
Productivity programs affect virtually all functional areas within the Company by reducing or eliminating waste and improving processes. We continue to expand our efforts surrounding global product and component sourcing and supplier cost reduction programs. Value engineering efforts, product transfers and the use of lean process improvement techniques are expected to continue to increase manufacturing efficiency. In addition, we continue to build upon the benefits of our enterprise resource planning system across all functions.
Acquisition of Aclara
On February 2, 2018 the Company acquired Aclara for approximately $1.1 billion. Aclara is a leading global provider of smart infrastructure solutions for electric, gas, and water utilities, with advanced metering solutions and grid monitoring sensor technology, as well as leading software enabled installation services. The acquisition extends the Power segment's capabilities into smart automation technologies, accelerates ongoing innovation efforts to address utility customer demand for data and integrated solutions, and expands the segment's reach to a broader set of utility customers.
For additional information about the Aclara acquisition, refer to Note 3 — Business Acquisitions and Dispositions in the Notes to the Consolidated Financial Statements.
| HUBBELL INCORPORATED - Form 10-K | 19 |
Results of Operations
Our operations are classified into two reportable segments: Electrical and Power. For a complete description of the Company’s segments, see Part I, Item 1 of this Annual Report on Form 10-K. Within these segments, Hubbell serves customers in five primary end markets: non-residential construction, residential construction, industrial, energy-related markets (also referred to as oil and gas markets) and utility markets (also referred to as the electrical transmission and distribution (T&D) market). In order of magnitude of net sales, the Company's served markets are electrical T&D, non-residential construction, industrial, oil and gas, and residential construction.
In 2019 we achieved two percent organic net sales growth on mixed end market trends. Our utility facing markets drove strong growth within our Power segment, resulting in organic net sales increasing by approximately 5.5% as compared to the prior year. End market performance within the Electrical segment was mixed, however, as non-residential and residential markets experienced modest growth, gas distribution markets remained solid, while industrial and oil markets were soft, resulting in a modest decline in organic net sales as compared to the prior year.
Operating margins expanded in both the Electrical and Power segments in 2019, driven by effective cost management and price realization. That expansion included the impact of increased investments in restructuring and related activities in 2019 and the effect of Section 301 tariffs on certain of our businesses (the "Tariffs" referred to in the following discussion of results of operations). In 2019, net income attributable to Hubbell grew by 11 percent compared to the prior year and diluted earnings per share grew by 12 percent. Adjusted net income(1) grew by four percent in 2019 compared to the prior year and adjusted diluted earnings per share(1) grew by five percent in 2019, reflecting our strong operating income performance.
Free cash flow was strong in 2019 at $497.7 million as compared to $420.9 million in the prior year(2). In 2019 we paid $186.6 million in shareholder dividends, an increase of eight percent as compared to the prior year, while also reducing our long term debt by $225.0 million and allocating approximately $71 million of capital to acquisitions.
(1) Adjusted net income and adjusted diluted earnings per share are non-GAAP financial measures. See "Adjusted Operating Measures" below for a reconciliation to the comparable GAAP financial measures.
(2) Free cash flow is a non-GAAP financial measure. See "Adjusted Operating Measures" and "Financial Condition, Liquidity and Capital Resources - Cash Flow" below for a reconciliation to the comparable GAAP financial measure.
SUMMARY OF CONSOLIDATED RESULTS (IN MILLIONS, EXCEPT PER SHARE DATA)
| For the Year Ending December 31, | |||||||||||||||
| 2019 | % of Net sales | 2018 | % of Net sales | 2017 | % of Net sales | ||||||||||
| Net sales | $ | 4,591.0 | $ | 4,481.7 | $ | 3,668.8 | |||||||||
| Cost of goods sold | 3,238.3 | 70.5 | % | 3,181.3 | 71.0 | % | 2,513.7 | 68.5 | % | ||||||
| Gross profit | 1,352.7 | 29.5 | % | 1,300.4 | 29.0 | % | 1,155.1 | 31.5 | % | ||||||
| Selling & administrative expenses | 756.1 | 16.5 | % | 743.5 | 16.6 | % | 636.3 | 17.3 | % | ||||||
| Operating income | 596.6 | 13.0 | % | 556.9 | 12.4 | % | 518.8 | 14.1 | % | ||||||
| Net income attributable to Hubbell | 400.9 | 8.7 | % | 360.2 | 8.0 | % | 243.1 | 6.6 | % | ||||||
| Less: Earnings allocated to participating securities | (1.5 | ) | (1.3 | ) | (0.8 | ) | |||||||||
| Adjusted net income available to common shareholders | 399.4 | 358.9 | 242.3 | ||||||||||||
| Average number of diluted shares outstanding | 54.7 | 54.9 | 55.1 | ||||||||||||
| EARNINGS PER SHARE - DILUTED | $ | 7.31 | $ | 6.54 | $ | 4.39 |
| 20 | HUBBELL INCORPORATED - Form 10-K |
Adjusted Operating Measures
In the following discussion of results of operations, we refer to "adjusted" operating measures. We believe those adjusted measures, which exclude the impact of certain costs, gains and losses, may provide investors with useful information regarding our underlying performance from period to period and allow investors to understand our results of operations without regard to items we do not consider a component of our core operating performance. Management uses these adjusted measures when assessing the performance of the business.
Effective with results of operations reported in the first quarter of 2019, "adjusted" operating measures exclude amortization of intangible assets associated with all of our business acquisitions, including inventory step-up amortization associated with those acquisitions. For comparability, all prior period "adjusted" operating measures as well as management's discussion and analysis have been updated to reflect this change in definition.
Adjusted operating measures in 2019 also exclude a gain on the disposition of the Haefely business, an investment loss as well as a 2019 net charge to recognize certain additional liabilities associated with the Company's previously disclosed withdrawal from a multi-employer pension plan. Those items are reported in Total other expense (below Operating income) in the Consolidated Statements of Income. Refer to Note 3 - Business Acquisitions and Dispositions, and Note 15 - Commitments and Contingencies in the Notes to Consolidated Financial Statements, for additional information.
Our adjusted operating measures also exclude Aclara transaction costs recognized in 2017 and 2018, income tax effects associated with U.S. tax reform recognized in 2017, and the loss on extinguishment of debt incurred in 2017 from the redemption of all of our $300 million outstanding long-term unsecured, unsubordinated notes that were scheduled to mature in 2018. However, the net tax benefit of approximately $6 million related to adjustments made in connection with the Company's accounting for the effects of TCJA during the measurement period in 2018 has not been reflected as an adjustment to the GAAP measures and is therefore not a reconciling item in the adjusted operating measures below.
The following table reconciles our adjusted financial measures to the directly comparable GAAP financial measure (in millions, except per share amounts):
| For the Year Ended December 31, | ||||||||||||
| 2019 | % of Net sales | 2018 | % of Net sales | 2017 | % of Net sales | |||||||
| Gross profit (GAAP measure) | $ | 1,352.7 | 29.5% | $ | 1,300.4 | 29.0% | $ | 1,155.1 | 31.5% | |||
| Amortization of acquisition-related intangible assets | 24.0 | 29.5 | — | |||||||||
| Adjusted gross profit | $ | 1,376.7 | 30.0% | $ | 1,329.9 | 29.7% | $ | 1,155.1 | 31.5% | |||
| S&A expenses (GAAP measure) | $ | 756.1 | 16.5% | $ | 743.5 | 16.6% | $ | 636.3 | 17.3% | |||
| Amortization of acquisition-related intangible assets | 48.1 | 46.4 | 34.9 | |||||||||
| Aclara transaction costs | — | 9.5 | 6.7 | |||||||||
| Adjusted S&A expenses | $ | 708.0 | 15.7% | $ | 687.6 | 15.3% | $ | 594.7 | 17.3% | |||
| Operating income (GAAP measure) | $ | 596.6 | 13.0% | $ | 556.9 | 12.4% | $ | 518.8 | 14.1% | |||
| Amortization of acquisition-related intangible assets | 72.1 | 75.9 | 34.9 | |||||||||
| Aclara transaction costs | — | 9.5 | 6.7 | |||||||||
| Adjusted operating income | $ | 668.7 | 14.6% | $ | 642.3 | 14.3% | $ | 560.4 | 15.3% | |||
| Net income attributable to Hubbell (GAAP measure) | $ | 400.9 | $ | 360.2 | $ | 243.1 | ||||||
| Amortization of acquisition-related intangible assets, net of tax | 53.9 | 57.5 | 22.0 | |||||||||
| Gain on disposition of business, net of tax | (20.5 | ) | — | — | ||||||||
| Multi-employer pension expense, net of tax | 6.4 | — | — | |||||||||
| Loss on investment, net of tax | 5.0 | — | — | |||||||||
| Aclara transaction costs, net of tax | — | 10.3 | 6.0 | |||||||||
| Income tax expense associated with U.S. tax reform | — | — | 56.5 | |||||||||
| Loss on early extinguishment of debt, net of tax | — | — | 6.3 | |||||||||
| Adjusted net income attributable to Hubbell | $ | 445.7 | $ | 428.0 | $ | 333.9 | ||||||
| Less: Earnings allocated to participating securities | (1.7 | ) | (1.5 | ) | (1.1 | ) | ||||||
| Adjusted net income available to common shareholders | $ | 444.0 | $ | 426.5 | $ | 332.8 | ||||||
| Average number of diluted shares outstanding | 54.7 | 54.9 | 55.1 | |||||||||
| ADJUSTED EARNINGS PER SHARE — DILUTED | $ | 8.12 | $ | 7.77 | $ | 6.03 |
| HUBBELL INCORPORATED - Form 10-K | 21 |
2019 Compared to 2018
Net Sales
Net sales of $4.6 billion in 2019 increased by two percent compared to 2018 primarily due to higher organic volume and the contribution of an additional month of net sales in 2019 associated with the Aclara acquisition which closed on February 2, 2018. Organic net sales growth contributed approximately two percentage points, including favorable price realization, and acquisitions added approximately one percentage point, partially offset by an approximately one percentage point decline in net sales from the disposal of the Haefely business and foreign exchange.
Cost of Goods Sold
As a percentage of net sales, cost of goods sold decreased by 50 basis points to 70.5% of net sales in 2019 as compared to 71.0% in 2018. The improvement was primarily driven by favorable price realization and savings from our productivity initiatives that outpaced cost increases as well as lower amortization of acquisition-related intangible assets, partially offset by higher restructuring and related costs, and lower net sales unit volume.
Gross Profit
The gross profit margin in 2019 increased by 50 basis points to 29.5% of net sales as compared to 29.0% in 2018. Excluding amortization of acquisition-related intangible assets, the adjusted gross profit margin was 30.0% in 2019 as compared to 29.7% in 2018 and increased primarily due to favorable price realization and savings from our productivity initiatives that outpaced cost increases, partially offset by higher restructuring and related costs, and lower net sales unit volume.
Selling & Administrative Expenses
S&A expense in 2019 was $756.1 million and increased by $12.6 million compared to the prior year. S&A expense as a percentage of net sales declined by 10 basis points from 16.6% in 2018 to 16.5% in 2019. Excluding amortization of acquisition-related intangible assets and Aclara transaction costs incurred in 2018, adjusted S&A expense as a percentage of net sales increased by 40 basis points from 15.3% in 2018 to 15.7% in 2019 primarily due to higher restructuring and related costs in 2019 partially offset by volume leverage associated with higher reported net sales dollars.
Operating Income
Operating income increased seven percent in 2019 to $596.6 million compared to 2018, and operating margin increased by 60 basis points to 13.0%. Excluding amortization of acquisition-related intangible assets and Aclara transaction costs incurred in 2018, adjusted operating income increased approximately four percent in 2019 to $668.7 million compared to 2018 and adjusted operating margin increased by 30 basis points to 14.6% in 2019. The increase in adjusted operating income and adjusted operating margin is the result of higher gross profit and expanding gross profit margin in 2019, from price realization and productivity in excess of cost increases, partially offset by the effect of lower unit volume, and higher restructuring and related costs.
Total Other Expense
Total other expense decreased by $13.8 million in 2019 to $76.1 million compared to the prior year primarily due to the impact of certain discrete non-operating items, including a $21.7 million gain recognized on the disposal of the Haefely business partially offset by an $8.5 million net charge associated with the withdrawal from a multi-employer pension plan and subsequent execution of a settlement agreement with regard to the withdrawal obligation, and a $5.0 million loss on an investment in an available-for-sale debt security. Interest expense, net of investment income, reported within total other expense for 2019 declined by $4.4 million as compared to the same period of the prior year.
Income Taxes
The effective tax rate was 21.7% in 2019 as compared to 21.6% in 2018. The increase in the effective tax rate is primarily due to the absence of favorable adjustments related to TCJA recorded in 2018, largely offset by the net favorable impact of dispositions, reserve releases related to statute of limitations expiration, and favorable provision to return adjustments recorded in 2019.
Net Income Attributable to Hubbell and Earnings Per Diluted Share
Net income attributable to Hubbell was $400.9 million in 2019 and increased 11% as compared to 2018. Excluding amortization of acquisition-related intangibles, Aclara transaction costs, and the impact of non-operating items within other expense, as described above, adjusted net income attributable to Hubbell was $445.7 million in 2019 and increased 4% as compared to 2018. Earnings per diluted share in 2019 increased 12% compared to 2018. Adjusted earnings per diluted share in 2019 increased 5% as compared to 2018 and reflects higher adjusted net income as well as a decline in the average number of diluted shares outstanding of 0.2 million as compared to the prior year.
Segment Results
Electrical Segment
| (in millions) | 2019 | 2018 | ||||
| Net sales | $ | 2,625.7 | $ | 2,660.6 | ||
| Operating income (GAAP measure) | $ | 320.1 | $ | 320.8 | ||
| Amortization of acquisition-related intangible assets | 23.1 | 23.9 | ||||
| Adjusted operating income | $ | 343.2 | $ | 344.7 | ||
| Operating margin | 12.2 | % | 12.1 | % | ||
| Adjusted operating margin | 13.1 | % | 13.0 | % |
Net sales of the Electrical segment in 2019 were $2.6 billion and decreased 130 basis points as compared to 2018 due to an approximately forty basis point decline in organic net sales growth, as the effect of lower unit volume was slightly greater than sales growth from favorable price realization, a fifty basis point decline in net sales due to the disposal of the Haefely business and a forty basis point decline from foreign exchange.
| 22 | HUBBELL INCORPORATED - Form 10-K |
Within the Electrical segment, the aggregate net sales of our Commercial and Industrial and Construction and Energy business groups were flat in 2019, as net sales growth from favorable price realization offset the effect of lower unit volume, the disposal of the Haefely business, and foreign exchange. Organic net sales growth of our products serving the natural gas distribution market was solid in 2019, while oil related markets were weak, industrial markets were soft and non-residential markets were mixed. Net sales of our Lighting business group decreased by approximately four percent in 2019 as the effect of lower unit volume outpaced favorable price realization. Within the Lighting business group, net sales of residential lighting products increased by approximately one percentage point and net sales of commercial and industrial lighting products declined by approximately five percentage points compared to 2018.
Operating income of the Electrical segment in 2019 was $320.1 million and was slightly lower compared to 2018. Operating margin in 2019 increased by 10 basis points to 12.2%. Excluding amortization of acquisition-related intangibles, adjusted operating margin also increased by 10 basis points to 13.1% primarily due to favorable price realization and productivity that were greater than cost increases (including Tariffs), partially offset by the impact of lower unit volume and higher restructuring and related costs. The operating margin decreased slightly in 2019 as compared to the prior year due to the disposal of the Haefely business.
Power Segment
| (in millions) | 2019 | 2018 | ||||
| Net sales | $ | 1,965.3 | $ | 1,821.1 | ||
| Operating income | $ | 276.5 | $ | 236.1 | ||
| Amortization of acquisition-related intangible assets | 49.0 | 52.0 | ||||
| Aclara transaction costs | — | 9.5 | ||||
| Adjusted operating income | $ | 325.5 | $ | 297.6 | ||
| Operating margin | 14.1 | % | 13.0 | % | ||
| Adjusted operating margin | 16.6 | % | 16.3 | % |
Net sales in the Power segment in 2019 were $2.0 billion, an increase of approximately 8% as compared to 2018, due to 5.5% of organic growth and approximately 3% of growth from acquisitions, partially offset by approximately 0.5% from foreign currency translation. Organic net sales growth was primarily driven by the transmission and distribution (T&D) market.
Operating income in the Power segment increased by 17% to $276.5 million in 2019 and operating margin in 2019 increased by 110 basis points to 14.1%. Excluding amortization of acquisition-related intangibles and Aclara transaction costs, the adjusted operating margin increased by 30 basis points to 16.6% primarily driven by favorable price realization and productivity which outpaced cost increases (including Tariffs), and a benefit from higher net sales volume, partially offset by one additional month of operating results of the Aclara business in 2019 and higher restructuring and related costs.
2018 Compared to 2017
Net Sales
Net sales of $4.5 billion in 2018 increased 22.2% percent compared to 2017 due to the contribution of net sales from acquisitions, higher organic volume and favorable price realization. Acquisitions added 17.8% to net sales, primarily from the acquisition of Aclara, while organic volume, including favorable price realization, contributed 4.4%. The effect of foreign exchange was flat compared to the prior year.
Cost of Goods Sold
As a percentage of net sales, cost of goods sold increased by 250 basis points to 71.0% of net sales in 2018 as compared to 68.5% in 2017. The increase was primarily driven by acquisitions, as 2018 includes $29.5 million of Aclara acquisition-related costs as well as the effect of adding the operating results of Aclara, which carries a relatively higher cost of goods sold as a percentage of net sales (and lower gross margin) as compared to the legacy Hubbell business. The increase also reflects an unfavorable net impact of price and material costs, as rising material costs and the impact of Tariffs outpaced favorable price realization.
Gross Profit
Gross profit margin in 2018 compared to 2017 declined by 250 basis points to 29.0% of net sales, driven by costs of goods sold discussed above. Excluding amortization of acquisition-related intangible assets, the adjusted gross profit margin was 29.7% in 2018 as compared to 31.5% in 2017.
Selling & Administrative Expenses
S&A expense in 2018 was $743.5 million and increased by $107.2 million compared to the prior year primarily due to the addition of S&A costs of Aclara, including $20.8 million of Aclara acquisition-related and transaction costs. S&A expense as a percentage of net sales declined by 70 basis points to 16.6% in 2018. Excluding amortization of acquisition-related intangible assets and Aclara transaction costs, adjusted S&A expense as a percentage of net sales declined by 200 basis points to 15.3% in 2018 primarily due to volume leverage associated with higher net sales.
Operating Income
Operating income increased seven percent in 2018 to $556.9 million, primarily driven by the operating results of the Aclara business, including acquisition-related and transaction costs. The increase in operating income from higher net sales volume was largely offset by rising material costs and the impact of Tariffs, which together, outpaced favorable price realization.
Operating margin decreased by 170 basis points to 12.4% due to higher amortization of acquisition-related intangible assets and Aclara transaction costs in 2018 as well as the operating results of the Aclara business, which carries a relatively lower gross margin as compared to the legacy Hubbell results. The decrease in operating margin also reflects the impact of material costs, tariffs and price realization noted above, which together were only partially offset by the benefit from higher net sales volume.
| HUBBELL INCORPORATED - Form 10-K | 23 |
Excluding amortization of acquisition-related intangible assets and Aclara transaction costs, adjusted operating income increased 14.6% percent in 2018 to $642.3 million and adjusted operating margin declined by 100 basis points to 14.3% in 2018.
Total Other Expense
Total other expense in 2018 was $89.9 million and increased by $14.2 million compared to the prior year, primarily due to higher interest expense from the issuance of $450 million of 2028 Notes and placement of the $500 million Term Loan, each in the first quarter of 2018, to finance the Aclara acquisition, partially offset by the loss on extinguishment of debt recognized in 2017 (which did not repeat in 2018).
Income Taxes
The effective tax rate was 21.6% in 2018 as compared to 43.6% in 2017. The decrease is primarily attributable to the absence of the $56.5 million provisional income tax expense associated with the TCJA recognized in the 2017 financial statements, the reduction of the federal income tax rate from 35% to 21% and net favorable adjustments to the 2017 provisional income tax expense associated with TCJA recognized in 2018 of approximately $6 million.
Additional information related to the Company’s effective tax rate is included in Note 13 — Income Taxes in the Notes to Consolidated Financial Statements
Net Income attributable to Hubbell and Earnings Per Diluted Share
Net income attributable to Hubbell was $360.2 million in 2018 and increased 48% as compared to 2017. The increase reflects a lower effective tax rate, higher operating income and the loss on extinguishment of debt in 2017 (which did not repeat in 2018), offset partially by higher interest expense. Adjusted net income attributable to Hubbell was $428.0 million in 2018 and increased 28% as compared to 2017. Earnings per diluted share in 2018 increased 49% compared to 2017. Adjusted earnings per diluted share in 2018 increased 29% as compared to 2017.
Segment Results
Electrical Segment
| (in millions) | 2018 | 2017 | ||||
| Net sales | $ | 2,660.6 | $ | 2,532.8 | ||
| Operating income | $ | 320.8 | $ | 294.0 | ||
| Amortization of acquisition-related intangible assets | 23.9 | 24.8 | ||||
| Adjusted operating income | $ | 344.7 | $ | 318.8 | ||
| Operating margin | 12.1 | % | 11.6 | % | ||
| Adjusted operating margin | 13.0 | % | 12.6 | % |
Net sales in the Electrical segment were $2.7 billion, up five percent in 2018 as compared with 2017 due to approximately five percentage points of net sales growth from higher organic volume, including favorable price realization for the segment. Acquisitions increased net sales by less than one percentage point and the effect of foreign currency translation was flat.
Within the segment, the aggregate net sales of our Commercial and Industrial and Construction and Energy business groups increased by seven percentage points, due to approximately six percentage points of organic growth, and approximately one percentage point of net sales growth from acquisitions. Organic net sales growth of these businesses was driven primarily by our products serving the energy-related markets as well as the non-residential and residential construction markets. Net sales of our Lighting business group increased approximately two percent in 2018 due to higher organic volume, partially offset by pricing headwinds. Within the Lighting business group, net sales of residential lighting products increased by 12%, driven by strong unit volume growth, while net sales of commercial and industrial lighting products declined by 2% as a result of lower volume and pricing headwinds.
Operating income in the Electrical segment for 2018 was $320.8 million and increased nine percent compared to 2017. Operating margin in 2018 increased by 50 basis points to 12.1%. The increase in operating margin is primarily due to incremental earnings on higher net sales, as discussed above, and productivity gains in excess of cost increases, partially offset by material cost headwinds (including the impact of Tariffs) that outpaced price realization. Excluding amortization of acquisition-related intangibles, adjusted operating margin increased by 40 basis points to 13.0%.
| 24 | HUBBELL INCORPORATED - Form 10-K |
Power Segment
| (in millions) | 2018 | 2017 | ||||
| Net sales | $ | 1,821.1 | $ | 1,136.0 | ||
| Operating income | $ | 236.1 | $ | 224.8 | ||
| Amortization of acquisition-related intangible assets | 52.0 | 10.1 | ||||
| Aclara transaction costs | 9.5 | 6.7 | ||||
| Adjusted operating income | $ | 297.6 | $ | 241.6 | ||
| Operating margin | 13.0 | % | 19.8 | % | ||
| Adjusted operating margin | 16.3 | % | 21.3 | % |
Net sales in the Power segment were $1.8 billion, up approximately 60% as compared to 2017, primarily due to the addition of net sales of the Aclara business as well as higher organic volume. Acquisitions contributed 56.6% to net sales growth and higher organic volume contributed 4.1%, including favorable price realization. Organic net sales growth was driven by the transmission and distribution (T&D) and telecommunications markets. Foreign exchange reduced net sales as compared to the prior year by less than one percentage point.
Operating income in the Power segment for 2018 increased by five percent to $236.1 million as compared to the prior year. Operating margin in 2018 decreased to 13.0% as compared to 19.8% in 2017 and reflects an approximately 2% decline from higher amortization of acquisition-related intangibles and Aclara transaction costs in 2018, as well as approximately 2% attributable to the lower margin operating results of the Aclara business. The decrease in operating margin also reflects a net headwind from material cost increases (including the impact of Tariffs) that outpaced price realization, and the absence of a one-time benefit in the fourth quarter of 2017. Excluding amortization of acquisition-related intangibles, adjusted operating margin in 2018 decreased to 16.3% as compared to 21.3% in 2017.
Financial Condition, Liquidity and Capital Resources
Cash Flow
| December 31, | |||||||||
| (in millions) | 2019 | 2018 | 2017 | ||||||
| Net cash provided by (used in): | |||||||||
| Operating activities | $ | 591.6 | $ | 517.1 | $ | 379.0 | |||
| Investing activities | (128.9 | ) | (1,201.4 | ) | (245.6 | ) | |||
| Financing activities | (471.0 | ) | 506.5 | (214.3 | ) | ||||
| Effect of foreign currency exchange rate changes on cash and cash equivalents | 1.3 | (8.2 | ) | 18.3 | |||||
| NET CHANGE IN CASH AND CASH EQUIVALENTS | $ | (7.0 | ) | $ | (186.0 | ) | $ | (62.6 | ) |
The following table reconciles our cash flows from operating activities to free cash flows for 2019, 2018 and 2017:
| December 31, | |||||||||
| (in millions) | 2019 | 2018 | 2017 | ||||||
| Net cash provided by operating activities (GAAP measure) | $ | 591.6 | $ | 517.1 | $ | 379.0 | |||
| Less: Capital expenditures | (93.9 | ) | (96.2 | ) | (79.7 | ) | |||
| Free cash flow | $ | 497.7 | $ | 420.9 | $ | 299.3 | |||
| Free cash flow as a percent of net income attributable to Hubbell (1) | 124.1 | % | 116.9 | % | 123.1 | % |
(1) Free cash flow as a percent of net income attributable to Hubbell, includes the approximately $57 million impact of the TCJA in 2017. Free cash flow as a percentage of net income attributable to Hubbell excluding the impact of the TCJA is approximately 100% in 2017.
Free cash flow is a non-GAAP measure that we define as cash flow from operations less capital expenditures. Management believes that free cash flow provides useful information regarding Hubbell’s ability to generate cash without reliance on external financing. In addition, management uses free cash flow to evaluate the resources available for investments in the business, strategic acquisitions and further strengthening the balance sheet.
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2019 Compared to 2018
Cash provided by operating activities for 2019 increased compared to 2018 primarily due to improvements within working capital. Cash provided by working capital was $22.2 million in 2019 as compared to cash used for working capital of $25.6 million in 2018, primarily due to lower accounts receivable and inventories, partially offset by lower accounts payable and other current liabilities.
Cash used for investing activities of $128.9 million in 2019 decreased compared to cash used of $1,201.4 million in 2018. This decrease is primarily due to approximately $70.8 million paid for acquisitions in 2019 compared to $1.1 billion paid for the acquisition of Aclara in 2018. Additionally, 2019 included $33.4 million of proceeds from the disposal of a business, as compared to none in 2018, and an $8.0 million decrease in the proceeds from sales of available-for-sale securities in 2019.
Cash used from financing activities was $471.0 million in 2019 compared to $506.5 million of cash provided in 2018. The change in cash flows from financing activities reflects the proceeds of the $450 million public debt offering in February 2018 and $500 million Term Loan issued in February 2018 to fund the acquisition of Aclara, compared to zero additional long term debt in 2019. Long-term debt repayments in 2019 were $56.2 million higher than in 2018 due to a $200 million discretionary payment in December 2019, partially offset by lower short term debt repayments of $37.2 million compared to 2018. Dividend payments to shareholders increased $14.3 million in 2019 compared to 2018.
The favorable effect of foreign currency exchange rates on cash was $1.3 million in 2019 as compared to an unfavorable effect of $8.2 million in 2018. The favorable effect in 2019 was primarily related to the U.S. dollar weakening against the Canadian dollar and Mexican peso.
2018 Compared to 2017
Cash provided by operating activities for 2018 increased compared to 2017 primarily due to a higher contribution from net income and the related non-cash adjustments for depreciation and amortization, partially offset by $26.2 million of additional pension funding in 2018 compared to 2017. Cash used for working capital was $25.6 million in 2018 compared to $29.0 million in 2017 primarily due to improved inventory management in 2018, partially offset by higher accounts receivables and Aclara related items, including cash payments for transaction costs in 2018.
Cash used for investing activities of $1,201.4 million in 2018 increased compared to cash used of $245.6 million in 2017. This increase was primarily due to approximately $1.1 billion paid for the acquisition of Aclara in 2018, $16.5 million of higher capital expenditures and an $11.6 million decrease in the proceeds from disposition of assets in 2018, as compared to 2017.
Cash provided from financing activities of $506.5 million in 2018 increased compared to $214.3 million of cash used in 2017. The change in cash flows from financing activities reflects the proceeds of the $450 million public debt offering in February 2018 and $500 million Term Loan issued in February 2018 to fund the acquisition of Aclara, as well as, lower share repurchases in 2018, partially offset by cash used to reduce short-term borrowings.
The unfavorable effect of foreign currency exchange rates on cash was $8.2 million in 2018 as compared to a favorable effect of $18.3 million in 2017. The unfavorable effect in 2018 was primarily related to the U.S. dollar strengthening against the Canadian dollar, Australian dollar and British pound.
Investments in the Business
Investments in our business include cash outlays for the acquisition of businesses as well as expenditures to maintain the operation of our equipment and facilities and invest in restructuring activities.
In the fourth quarter of 2019, the Company acquired all of the issued and outstanding shares of Cantega Technologies Inc., including its wholly owned subsidiary Greenjacket Inc., and all of the issued and outstanding shares of Reliaguard Inc. (collectively “Cantega”) for $36.3 million, net of cash acquired, and the Company also acquired substantially all of the assets of Connector Products, Incorporated (“CPI”) for $28.0 million.
In February 2018, the Company completed the acquisition of Aclara for approximately $1.1 billion in an all-cash transaction. To fund the Aclara acquisition, on February 2, 2018 the Company borrowed $500 million under a Term Loan Agreement with a syndicate of lenders, issued $450 million of unsecured, 3.50% senior notes maturing in 2028, and the remaining purchase price and transaction expenses were funded with commercial paper. Refer to Note 3 — Business Acquisitions and Note 12 — Debt in the Notes to Consolidated Financial Statements for additional information.
We continue to invest in restructuring and related programs to maintain a competitive cost structure, drive operational efficiency and mitigate the impact of rising material costs and administrative cost inflation. We expect our investment in restructuring and related activities in 2020 to continue as we continue to invest in previously initiated actions and initiate further footprint consolidation and other cost reduction initiatives.
In connection with our restructuring and related actions, we have incurred restructuring costs as defined by U.S. GAAP, which are primarily severance and employee benefits, asset impairments, accelerated depreciation, as well as facility closure, contract termination and certain pension costs that are directly related to restructuring actions. We also incurred restructuring-related costs, which are costs associated with our business transformation initiatives, including the consolidation of back-office functions and streamlining our processes, and certain other costs and gains associated with restructuring actions. We refer to these costs on a combined basis as "restructuring and related costs", which is a non-GAAP measure. We believe this non-GAAP measure provides investors with useful information regarding our underlying performance from period to period.
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Restructuring costs are predominantly settled in cash from our operating activities and are generally settled within one year, with the exception of asset impairments, which are non-cash.
The table below presents the restructuring and related costs incurred in 2019, additional expected costs, and the expected completion date of restructuring actions that have been initiated as of December 31, 2019 (in millions):
| Costs Incurred in 2019 | Additional Expected Costs | Expected Completion Date | |||||
| 2019 Restructuring Actions | $ | 29.1 | $ | 13.1 | 2021 | ||
| 2018 and Prior Restructuring Actions | 2.9 | 1.7 | 2020 | ||||
| Restructuring cost (GAAP measure) | $ | 32.0 | $ | 14.8 | |||
| Restructuring-related costs | 5.0 | 1.5 | |||||
| Restructuring and related costs (Non-GAAP) | $ | 37.0 | $ | 16.3 |
During 2019, we invested $93.9 million in capital expenditures, as we continue to make investments in facilities and equipment to support our on-going focus on productivity.
Stock Repurchase Program
On October 20, 2017, the Board of Directors approved a stock repurchase program (the “October 2017 program”) that authorized the repurchase of up to $400 million of Common Stock and expires on October 20, 2020. The Company repurchased $35.0 million and $40.0 million of shares of Common Stock, in 2019 and 2018, respectively, and the remaining share repurchase authorization under the October 2017 program is $325.0 million as of December 31, 2019. Subject to numerous factors, including market conditions and alternative uses of cash, we may conduct discretionary repurchases through open market or privately negotiated transactions, which may include repurchases under plans complying with Rules 10b5-1 and 10b-18 under the Securities Exchange Act of 1934, as amended.
Debt to Capital
At December 31, 2019 and 2018, the Company had $1,506.0 million and $1,737.1 million, respectively, of long-term debt outstanding, net of unamortized discount and the unamortized balance of capitalized debt issuance costs. At December 31, 2019 and 2018 the Company also had $34.4 million and $25.0 million, respectively of long-term debt classified as short-term on the Consolidated Balance Sheets, reflecting maturities due within the next 12 months.
Principal amounts of long-term debt at December 31, 2019 consisted of unsecured, senior notes in principal amounts of $300 million due in 2022, $400 million due in 2026, $300 million due in 2027, and $450 million due in 2028 (collectively, the "Notes") as well as $106.3 million remaining principal amount of borrowing under a term loan agreement.
The 2028 Notes were issued in February 2018 and bear interest at a fixed rate of 3.50%. Net proceeds from the issuance of the 2028 Notes were $442.6 million after deducting the discount on the notes and offering expenses paid by the Company.
The 2027 Notes were issued in August 2017 and bear interest at a fixed rate of 3.15%. Net proceeds from the issuance were $294.6 million after deducting the discount on the notes and offering expenses paid by the Company. In September 2017, the Company applied the net proceeds from the 2027 Notes to redeem all of its $300 million of long-term, unsecured, unsubordinated notes maturing in 2018 and bearing interest at a fixed rate of 5.95%. In connection with this redemption, the Company recognized a loss on the early extinguishment of the 2018 Notes of $6.3 million on an after-tax basis.
The Notes are callable at any time at specified prices and are only subject to accelerated payment prior to maturity upon customary events of default under the indentures governing such Notes, or upon a change in control triggering event as defined in such indentures. The Company was in compliance with all covenants (none of which are financial) as of December 31, 2019.
On January 31, 2018, the Company entered into a Term Loan Agreement (the “Term Loan Agreement”) with a syndicate of lenders under which the Company borrowed $500 million on an unsecured basis to partially finance the Aclara acquisition on February 2, 2018.
Pursuant to the contractual loan amortization schedule, $34.4 million and $25 million of borrowings under the Term Loan Agreement are classified as short-term within current liabilities on the December 31, 2019 and 2018 Consolidated Balance Sheets.
At December 31, 2019 and 2018, the Company had $65.4 million and $56.1 million, respectively, of short-term debt outstanding composed of;
| ◦ | $26.0 million of commercial paper borrowings outstanding at December 31, 2019 and 2018. |
| ◦ | $34.4 million at December 31, 2019 and $25.0 million at December 31, 2018, respectively, of long-term debt classified as short-term within current liabilities in the Consolidated Balance Sheets, reflecting maturities within the next twelve months relating to our borrowing under the Term Loan Agreement. |
| ◦ | $5.0 million at December 31, 2019 and $5.1 million at December 31, 2018, respectively, of borrowings to support our international operations in China. |
Net debt, defined as total debt less cash and investments, is a non-GAAP measure that may not be comparable to definitions used by other companies. We consider net debt to be a useful measure of our financial leverage for evaluating the Company’s ability to meet its funding needs.
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The following table sets forth the reconciliation of net debt at December 31, 2019 and 2018:
| December 31, | ||||||
| (in millions) | 2019 | 2018 | ||||
| Total Debt | $ | 1,571.4 | $ | 1,793.2 | ||
| Total Hubbell Shareholders’ Equity | 1,947.1 | 1,780.6 | ||||
| TOTAL CAPITAL | $ | 3,518.5 | $ | 3,573.8 | ||
| Debt to Total Capital | 45 | % | 50 | % | ||
| Cash and Investments | $ | 251.9 | $ | 254.5 | ||
| NET DEBT | $ | 1,319.5 | $ | 1,538.7 | ||
| Net Debt to Total Capital | 38 | % | 43 | % |
Liquidity
We measure liquidity on the basis of our ability to meet short-term and long-term operational funding needs, fund additional investments, including acquisitions, and make dividend payments to shareholders. Significant factors affecting the management of liquidity are cash flows from operating activities, capital expenditures, cash dividend payments, stock repurchases, access to bank lines of credit and our ability to attract long-term capital with satisfactory terms.
In 2019, we invested in acquisitions and also returned capital to our shareholders through dividends and share repurchases. These activities were funded primarily with cash flows from operations and proceeds from the disposal of the Haefely business.
| ◦ | Cash used for the acquisition of businesses in 2019, net of cash acquired was $70.8 million, including cash settlement of a deferred purchase price obligation related to a previous acquisition. Further discussion of our acquisitions can be found in Note 3 — Business Acquisitions and Dispositions in the Notes to Consolidated Financial Statements. |
| ◦ | In 2019, cash used for share repurchases was $35.0 million. Dividends paid on our Common Stock in 2019 were $186.6 million. |
We also require cash outlays to fund our operations, capital expenditures, and working capital requirements to accommodate anticipated levels of business activity, as well as our rate of cash dividends and potential future acquisitions. We have contractual obligations for long-term debt, operating leases, purchase obligations, and certain other long-term liabilities that are summarized in the table of Contractual Obligations as of December 31, 2019. As a result of the TCJA, we also have an obligation to fund, over the next six years, the Company's liability for the transition tax on the 2017 deemed repatriation of foreign earnings.
Our sources of funds and available resources to meet these funding needs are as follows:
| ◦ | Cash flows from operations and existing cash resources: We held $182.0 million of cash and cash equivalents at December 31, 2019, of which approximately 12% was held inside the United States and the remainder held internationally. The Company repatriated a portion of its foreign earnings in 2019. The consolidated financial statements reflect the income tax effects of the repatriation of these earnings as well as the income tax effects of certain anticipated future cash repatriations. |
| ◦ | On January 31, 2018, the Company entered into the Term Loan Agreement and a five-year revolving credit agreement (the "2018 Credit Facility") with a syndicate of lenders that provides a $750 million committed revolving credit facility and terminated all commitments under the Company's previous credit facility. Commitments under the 2018 Credit Facility may be increased (subject to certain conditions) to an aggregate amount not to exceed $1.250 billion. The interest rate applicable to borrowings under the 2018 Credit Facility is generally either the adjusted LIBOR plus an applicable margin (determined by a ratings based grid) or the alternate base rate. The single financial covenant in the 2018 Credit Facility requires that total debt not exceed 65% of total capitalization as of the last day of each fiscal quarter of the Company. The 2018 Credit Facility expires in February 2023. As of December 31, 2019 the Company had not drawn against the 2018 Credit Facility. |
Annual commitment fees to support availability under the 2018 Credit Facility are not material. Although not the principal source of liquidity, we believe our 2018 Credit Facility is capable of providing significant financing flexibility at reasonable rates of interest. However, an increase in usage of the 2018 Credit Facility related to growth or a significant deterioration in the results of our operations or cash flows, could cause our borrowing costs to increase and/or our ability to borrow could be restricted. We have not entered into any guarantees that could give rise to material unexpected cash requirements.
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| ◦ | The interest rate applicable to borrowings under the Term Loan Agreement is generally either adjusted LIBOR plus an applicable margin (determined by a ratings based grid) or the alternate base rate. The sole financial covenant in the Term Loan Agreement requires that total debt not exceed 65% of total capitalization as of the last day of each fiscal quarter of the Company. |
The principal amount of borrowings under the Term Loan Agreement amortize in equal quarterly installments of 5% per year in year one, 5% per year in year two, 7.5% per year in year three, 10% per year in year four, 10% per year in year five, and any remaining borrowings under the Term Loan Agreement are due and payable in full in February 2023. The Company may also make principal payments in excess of the amortization schedule at its discretion and, during 2018 and 2019, the Company made $150 million and $200 million, respectively, of such principal payments.
| ◦ | In addition to our commercial paper program and existing revolving credit facility, we also have the ability to obtain additional financing through the issuance of long-term debt. Considering our current credit rating, historical earnings performance, and financial position we believe that we would be able to obtain additional long-term debt financing on attractive terms. |
| ◦ | The Company also maintains other lines of credit that are primarily used to support the issuance of letters of credit. Interest rates and other terms of borrowing under these lines of credit vary from country to country, depending on local market conditions. At December 31, 2019 and 2018, total availability under these lines was $23.0 million and $54.8 million, respectively, of which $15.7 million and $20.3 million was utilized to support letters of credit and the remaining amount was unused. The annual commitment fees associated with these lines of credit are not material. |
Pension Funding Status
We have a number of funded and unfunded non-contributory U.S. and foreign defined benefit pension plans. Benefits under these plans are generally provided based on either years of service and final average pay or a specified dollar amount per year of service. The funded status of our qualified, defined benefit pension plans is dependent upon many factors including future returns on invested pension assets, the level of market interest rates, employee earnings and employee demographics.
In 2019, the Company approved amendments to one of its domestic qualified defined benefit pension plans, which froze service accruals for nearly all active participants within the plan effective January 1, 2020. As a result of the amendment, the Company recognized a $0.3 million curtailment charge, net of tax.
In 2018, the Company approved amendments to one of its foreign defined benefit pension plans, which closed the plan to future service accruals effective August 31, 2018. As a result of the amendments, in the third quarter of 2018, the Company recognized a curtailment gain of approximately $4.7 million, net of tax, in accumulated other comprehensive income. In addition, effective August 31, 2018, the amortization of actuarial gains and losses is being recognized over the remaining life expectancy of the participants of this plan, as all participants are considered inactive as a result of the amendment.
In 2018, we completed transactions with a third-party insurer to settle approximately $28 million of projected benefit obligations of our domestic qualified defined benefit pension plans.
Changes in the value of the defined benefit plan assets and liabilities will affect the amount of pension expense ultimately recognized. Although differences between actuarial assumptions and actual results are no longer deferred for balance sheet purposes, deferral is still permitted for pension expense purposes. Unrecognized gains and losses in excess of an annual calculated minimum amount (the greater of 10% of the projected benefit obligation or 10% of the market value of assets) have been amortized and recognized in net periodic pension cost. Effective January 1, 2020, the amortization of unrecognized gains and losses of all of the Company's qualified defined benefit pension plans is recognized over the remaining life expectancy of participants, as all participants are considered inactive as a result of plan amendments. During 2019 and 2018, we recorded $9.6 million and $10.5 million, respectively, of pension expense related to the amortization of these unrecognized losses.
In 2019, 2018 and 2017, we contributed $10.4 million, $27.9 million, and $1.7 million, respectively, to our qualified foreign and domestic defined benefit pension plans. These contributions have improved the funded status of those plans. Although not required by ERISA and the Internal Revenue Code, the Company may elect to make a voluntary contribution to its qualified domestic defined benefit pension plan in 2020. The Company expects to contribute approximately $4.3 million to its foreign plans in 2020. The anticipated level of pension funding in 2020 is not expected to have a significant impact on our overall liquidity.
| HUBBELL INCORPORATED - Form 10-K | 29 |
Assumptions
The following assumptions were used to determine projected pension and other benefit obligations at the measurement date and the net periodic benefit costs for the year:
| Pension Benefits | Other Benefits | ||||||||
| 2019 | 2018 | 2019 | 2018 | ||||||
| Weighted-average assumptions used to determine benefit obligations at December 31, | |||||||||
| Discount rate | 3.17 | % | 4.24 | % | 3.30 | % | 4.40 | % | |
| Rate of compensation increase | 2.94 | % | 3.25 | % | 4.00 | % | 4.05 | % | |
| Weighted-average assumptions used to determine net periodic benefit cost for years ended December 31, | |||||||||
| Discount rate | 4.24 | % | 3.67 | % | 4.40 | % | 3.70 | % | |
| Expected return on plan assets | 4.75 | % | 4.68 | % | N/A | N/A | |||
| Rate of compensation increase | 3.25 | % | 3.24 | % | 4.05 | % | 4.00 | % |
At the end of each year, we estimate the expected long-term rate of return on pension plan assets based on the strategic asset allocation for our plans. In making this determination, we utilize expected rates of return for each asset class based upon current market conditions and expected risk premiums for each asset class. A one percentage point change in the expected long-term rate of return on pension fund assets would have an impact of approximately $7.4 million on 2020 pretax pension expense. The expected long-term rate of return is applied to the fair market value of pension fund assets to produce the expected return on fund assets that is included in pension expense.
The difference between this expected return and the actual return on plan assets was recognized at December 31, 2019 for balance sheet purposes, but continues to be deferred for expense purposes. The net deferral of past asset gains (losses) ultimately affects future pension expense through the amortization of gains (losses) with an offsetting adjustment to Hubbell shareholders’ equity through Accumulated other comprehensive loss.
At the end of each year, we determine the discount rate to be used to calculate the present value of our pension plan liabilities. For our U.S. and Canadian pension plans, this discount rate is determined by matching the expected cash flows associated with our benefit obligations to the expected cash flows of a hypothetical portfolio of high quality, fixed income debt instruments with maturities that closely match the expected funding period of our pension liabilities. As of December 31, 2019, we used a discount rate of 3.30% for our U.S. pension plans compared to a discount rate of 4.40% used in 2018. For our Canadian pension plan, we used a discount rate of 3.00% in 2019, compared to the 3.60% discount rate used in 2018.
For our UK pension plan the discount rate was derived using a full yield curve and uses plan specific cash flows. The derived discount rate is the single discount rate equivalent to discounting these liability cash flows at the term-dependent spot rates of AA corporate bonds. This methodology resulted in a December 31, 2019 discount rate for the UK pension plan of 2.10% as compared to a discount rate of 2.90% used in 2018.
A decrease of one percentage point in the discount rate would lower our 2020 pretax pension expense by approximately $0.1 million. A discount rate increase of one percentage point would increase our 2020 pretax pension expense by an immaterial amount.
In 2019 we changed the mortality table used to calculate the present value of our pension plan liabilities from the RP-2014 mortality table, with generational projection from 2006 using Scale MP-2018 to the Pri-2012 mortality table, with generational projection from 2012 using Scale MP-2019. That change did not have a material impact to the projected benefit obligation of our U.S. plans upon remeasurement at December 31, 2019. The Pri-2012 mortality table, with generational projection from 2012 using Scale MP-2019 was chosen as the best estimate based on the observed and anticipated experience of the plans after considering alternative tables.
Other Post Employment Benefits (“OPEB”)
The Company also has a number of health care and life insurance benefit plans covering eligible employees who reached retirement age while working for the Company. These benefits have been discontinued for substantially all future retirees. These plans are not funded and, therefore, no assumed rate of return on assets is required. We use a similar methodology to derive the yield curve for our post employment benefit plan obligations that we use for our pension plans. As of December 31, 2019, the Company used a discount rate of 3.30% to determine the projected benefit obligation compared to a discount rate of 4.40% used in 2018.
In accordance with the accounting guidance for retirement benefits, we recorded to Accumulated other comprehensive loss, within Hubbell shareholders’ equity, a benefit, net of tax, of approximately $0.9 million in 2019 and a charge, net of tax, of approximately $0.3 million in 2018, related to the annual remeasurement of the OPEB plans and the amortization of prior service credits and net actuarial gains.
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Off-Balance Sheet Arrangements
Off-balance sheet arrangements are defined as any transaction, agreement or other contractual arrangement to which an entity that is not included in our consolidated results is a party, under which we, whether or not a party to the arrangement, have, or in the future may have: (1) an obligation under a direct or indirect guarantee or similar arrangement, (2) a retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement that serves as credit, liquidity or market risk support to such entity for such assets, (3) an obligation or liability, including a contingent obligation or liability, under a contract that would be accounted for as a derivative instrument, except that it is excluded from the scope of FASB ASC Topic 815, or (4) an obligation, including a contingent obligation, arising out of a variable interest in an unconsolidated entity that is held by, and material to, the Company, where such entity provides financing, liquidity, market risk or credit risk support to, or engages in leasing, hedging or research and development services with, the Company.
We do not have any off-balance sheet arrangements as defined above which have or are likely to have a current or future material effect on our financial condition, results of operations, liquidity, capital expenditures, capital resources or cash flows.
Contractual Obligations
A summary of our contractual obligations and commitments at December 31, 2019 is as follows (in millions):
| Payments due by period | |||||||||||||||
| Total | 2020 | 2021-2022 | 2023-2024 | 2025 and thereafter | |||||||||||
| Debt obligations(a) | $ | 1,521.9 | $ | — | $ | 371.9 | $ | — | $ | 1,150.0 | |||||
| Short-term debt obligations(a) | 65.4 | 65.4 | — | — | — | ||||||||||
| Expected interest payments | 318.7 | 52.3 | 99.5 | 77.2 | 89.7 | ||||||||||
| Operating lease obligations | 110.6 | 32.7 | 40.4 | 21.6 | 15.9 | ||||||||||
| Retirement and other benefits(b) | 195.2 | 13.9 | 20.9 | 16.8 | 143.6 | ||||||||||
| Purchase obligations | 324.7 | 315.8 | 8.9 | — | — | ||||||||||
| Obligations under customer incentive programs | 49.0 | 49.0 | — | — | — | ||||||||||
| Income tax payments(c) | 34.6 | 5.9 | 6.2 | 13.1 | 9.4 | ||||||||||
| TOTAL | $ | 2,620.1 | $ | 535.0 | $ | 547.8 | $ | 128.7 | $ | 1,408.6 |
| (a) | Amounts exclude unamortized discount and capitalized debt issuance costs. |
| (b) | Amounts above reflect projected funding related to the Company’s non-qualified defined benefit pension and OPEB plans as well as remaining payments under the multi-employer pension settlement agreement described in Note 15 – Commitments & Contingencies. Projected funding obligations of the Company’s qualified defined benefit pension plans are excluded from the table as there are significant factors, such as the future market value of plan assets and projected investment return rates, which could cause actual funding requirements to differ materially from projected funding. |
| (c) | Amount above includes future payments associated with the one-time transition tax under the TCJA. |
Our purchase obligations include amounts committed under legally enforceable contracts or purchase orders for goods and services with defined terms as to price, quantity, delivery and termination liability. These obligations primarily consist of inventory purchases made in the normal course of business to meet operational requirements and commitments for equipment purchases. As of December 31, 2019, we have $41.9 million of uncertain tax positions reflected in our Consolidated Balance Sheet. We are unable to make a reasonable estimate regarding the timing of settlement of these uncertain tax positions and, as a result, they have been excluded from the table. See Note 13 — Income Taxes in the Notes to Consolidated Financial Statements.
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Critical Accounting Estimates
Note 1 — Significant Accounting Policies in the Notes to Consolidated Financial Statements describes the significant accounting policies used in the preparation of our financial statements.
Use of Estimates
We are required to make assumptions and estimates and apply judgments in the preparation of our financial statements that affect the reported amounts of assets and liabilities, revenues and expenses and related disclosures. We base our assumptions, estimates and judgments on historical experience, current trends and other factors deemed relevant by management. We continually review these estimates and their underlying assumptions to ensure they are appropriate for the circumstances. Changes in estimates and assumptions used by us could have a material impact on our financial results. We believe that the following estimates are among the most critical in fully understanding and evaluating our reported financial results. These items utilize assumptions and estimates about the effect of future events that are inherently uncertain and are based on our judgment.
Revenue Recognition
The Company recognizes revenue when performance obligations identified under the terms of contracts with its customers are satisfied, which generally occurs, for products, upon the transfer of control in accordance with the contractual terms and conditions of the sale. The majority of the Company’s revenue associated with products is recognized at a point in time when the product is shipped to the customer, with a relatively small amount of transactions in the Power segment recognized upon delivery of the product at the contractually specified destination. Revenue from service contracts and post-shipment performance obligations is approximately three percent of total annual consolidated net revenue and those service contracts and post-shipment obligations are primarily within the Power segment. Revenue from service contracts and post-shipment performance obligations is recognized when or as those obligations are satisfied. The Company primarily offers assurance-type standard warranties that do not represent separate performance obligations and on occasion will separately offer and price extended warranties that are separate performance obligations for which the associated revenue is recognized over-time based on the extended warranty period. The Company records amounts billed to customers for reimbursement of shipping and handling costs within revenue. Shipping and handling costs associated with outbound freight after control over a product has transferred to a customer are accounted for as fulfillment costs and are included in cost of goods sold. Sales taxes and other usage-based taxes are excluded from revenue.
The Company has certain arrangements that require us to estimate at the time of sale the amounts of variable consideration that should not be recorded as revenue as certain amounts are not expected to be collected from customers, as well as an estimate of the value of the product to be returned. The Company principally relies on historical experience, specific customer agreements and anticipated future trends to estimate these amounts at the time of shipment and to reduce the transaction price. These arrangements include sales discounts and allowances based on sales volumes, specific programs and special pricing allowances, and returned goods, as are customary in the electrical products industry. Customer returns have historically ranged from 1%-2% of gross sales.
Inventory Valuation
Inventories in the U.S. are primarily valued at the lower of LIFO cost or market, while non-U.S. inventories are valued at the lower of FIFO cost or market. We routinely evaluate the carrying value of our inventories to ensure they are carried at the lower of LIFO or FIFO cost or market value. Such evaluation is based on our judgment and use of estimates, including sales forecasts, gross margins for particular product groupings, planned dispositions of product lines, technological events and overall industry trends. In addition, the evaluation is based on changes in inventory management practices which may influence the timing of exiting products and method of disposing of excess inventory.
Excess inventory is generally identified by comparing future expected inventory usage to actual on-hand quantities. Inventory values are reduced for on-hand inventory in excess of pre-defined usage forecasts. Forecast usage is primarily determined by projecting historical (actual) sales and inventory usage levels forward to future periods. Changes in these estimates may necessitate future adjustments to inventory values.
Customer Credit and Collections
We maintain allowances for doubtful accounts receivable in order to reflect the potential uncollectability of receivables related to purchases of products on open credit. If the financial condition of our customers were to deteriorate, resulting in their inability to make required payments, we may be required to record additional allowances for doubtful accounts.
Accrued Insurance
We retain a significant portion of the risks associated with workers’ compensation, medical, automobile and general liability insurance. We estimate self-insurance liabilities using a number of factors, including historical claims experience, demographic factors, severity factors and other actuarial assumptions. The accrued liabilities associated with these programs are based on our estimates of ultimate costs to settle known claims as well as claims incurred but not reported as of the balance sheet date. These assumptions are periodically reviewed with a third-party actuary to determine the adequacy of these self-insurance reserves. Changes in these assumptions may necessitate future adjustments to these self-insurance liabilities.
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Employee Benefits Costs and Funding
We sponsor domestic and foreign defined benefit pension, defined contribution and other postretirement plans. Significant assumptions used in the accounting for these employee benefit plans include the discount rate, expected return on the pension fund assets, rate of increase in employee compensation levels and health care cost increase projections. These assumptions are determined based on Company data and appropriate market indicators, and are evaluated each year as of the plans’ measurement dates. Further discussion of the assumptions used in 2019 and 2018 are included above under “Pension Funding Status” and in Note 11 — Retirement Benefits in the Notes to Consolidated Financial Statements.
Taxes
We account for income taxes in accordance with the applicable accounting guidance which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax basis of recorded assets and liabilities. Additionally, deferred tax assets are required to be reduced by a valuation allowance if it is more-likely-than-not that some portion or all of a deferred tax asset will not be realized. The factors used to assess the likelihood of realization of deferred tax assets are the forecast of future taxable income, available tax planning strategies that could be implemented to realize the net deferred tax assets, and future reversals of deferred tax liabilities. Failure to achieve forecasted taxable income can affect the ultimate realization of net deferred tax assets.
We operate within multiple taxing jurisdictions and are subject to audit in these jurisdictions. The Internal Revenue Service (“IRS”) and other tax authorities routinely review our tax returns. These audits can involve complex issues, which may require an extended period of time to resolve. The Company records uncertain tax positions when it has determined that it is more-likely-than-not that a tax position will not be sustained upon examination by taxing authorities based on the technical merits of the position. The Company uses the criteria established in the accounting guidance to determine whether an item meets the definition of more-likely-than-not. The Company’s policy is to recognize these uncertain tax positions when the more-likely-than-not threshold is met, when the statute of limitations has expired or upon settlement. In management’s opinion, adequate provision has been made for potential adjustments arising from any examinations. See Note 13 — Income Taxes in the Notes to Consolidated Financial Statements.
Contingent Liabilities
We are subject to proceedings, lawsuits, and other claims or uncertainties related to environmental, legal, product and other matters. We routinely assess the likelihood of an adverse judgment or outcome to these matters, as well as the range of potential losses. We record a liability when it is both probable that a liability has been incurred and the amount can be reasonably estimated. A determination of the reserves required, if any, is made after careful analysis, including consultations with outside advisors, where applicable. Where no amount within a range of estimates is more likely, the minimum is accrued. The required reserves may change in the future due to new developments.
Warranty
The Company offers product warranties that cover defects on most of its products. These warranties primarily apply to products that are properly installed, maintained and used for their intended purpose. The Company accrues estimated warranty costs at the time of sale. Estimated warranty expenses, recorded in cost of goods sold, are based upon historical information such as past experience, product failure rates, or the estimated number of units to be repaired or replaced. Adjustments are made to the product warranty accrual as claims are incurred, additional information becomes known or as historical experience indicates.
Valuation of Long-Lived Assets
Our long-lived assets include land, buildings, equipment, molds and dies, software, goodwill and other intangible assets. Long-lived assets, other than land, goodwill and indefinite-lived intangibles, are depreciated over their estimated useful lives. The assets and liabilities of acquired businesses are recorded under the acquisition method of accounting at their estimated fair values at the dates of acquisition. Goodwill represents purchase price in excess of fair values assigned to the underlying identifiable net assets of acquired businesses. Intangible assets primarily consist of patents, tradenames, developed technology and customer related intangibles.
We review depreciable long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount may not be fully recoverable. If such a change in circumstances occurs, the related estimated future undiscounted cash flows expected to result from the use of the asset group and its eventual disposition is compared to the carrying amount. If the sum of the expected cash flows of the asset group is less than the carrying amount, an impairment charge is recorded. The impairment charge is measured as the amount by which the carrying amount exceeds the fair value of the asset. The fair value of impaired assets is determined using expected cash flow estimates, quoted market prices when available and appraisals as appropriate. We did not record any material impairment charges related to long-lived assets in 2019, 2018, or 2017.
Goodwill and indefinite-lived intangible assets are reviewed annually for impairment unless circumstances dictate the need for more frequent assessment. We perform our goodwill impairment testing as of April 1st of each year unless circumstances dictate the need for more frequent assessments. The accounting guidance provides entities an option of performing a qualitative assessment before performing a quantitative analysis. If the entity determines, on the basis of certain qualitative factors, that it is more-likely-than-not that the goodwill is not impaired, the entity would not need to proceed to the quantitative goodwill impairment testing process as prescribed in the guidance. The Company performed a qualitative assessment for four of its seven reporting units. The Company elected to bypass the qualitative assessment and proceeded directly to the quantitative analysis for its remaining reporting units.
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The goodwill impairment test requires judgment, including the identification of reporting units, assigning assets and liabilities to reporting units, and determining the fair value of each reporting unit. Significant judgments required to estimate the fair value of reporting units include estimating future discounted cash flows, determining appropriate discount rates and other assumptions. We use internal discounted cash flow estimates to determine fair value. These cash flow estimates are derived from historical experience and future long-term business plans and include assumptions of future sales growth, gross margin, operating margin, terminal growth rate, and the application of an appropriate discount rate. Changes in these estimates and assumptions could materially affect the determination of fair value and/or goodwill impairment for each reporting unit. As of April 1, 2019, our goodwill testing resulted in fair values for each reporting unit that substantially exceeded the reporting unit’s carrying value. We have not recorded any goodwill impairments since the initial adoption of the accounting guidance in 2002.
The identification and measurement of impairment of indefinite-lived intangible assets involves an assessment of qualitative factors to determine whether events or circumstances indicate that it is more-likely-than-not that an indefinite-lived intangible asset is impaired. If it is more-likely-than-not that the asset is impaired, the fair value of the indefinite lived intangibles will be determined using discounted cash flow estimates. If the carrying value of these assets exceeds the estimated fair value, the carrying value will be reduced to the estimated fair value. We did not record any impairments related to indefinite-lived intangible assets in 2019, 2018, or 2017.
Stock-Based Compensation
We determine the grant date fair value of certain stock-based compensation awards using either a lattice model or the Black-Scholes option pricing model. Both of these models require management to make certain assumptions with respect to selected model inputs. These inputs include assumptions for the expected term, stock volatility, dividend yield and risk-free interest rate. Changes in these inputs impact fair value and could impact our stock-based compensation expense in the future. In addition, we are required to estimate the expected forfeiture rate and recognize expense only for those awards expected to meet the service and performance vesting conditions. If our actual forfeiture rate is different from our estimate, adjustments to stock-based compensation expense may be required. See also Note 17 — Stock-Based Compensation in the Notes to Consolidated Financial Statements.
Forward-Looking Statements
Some of the information included in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, and elsewhere in this Form 10-K, contain “forward-looking statements” as defined by the Private Securities Litigation Reform Act of 1995. These include statements about our expected capital resources, liquidity, financial performance, pension funding, and results of operations and are based on our reasonable current expectations. In addition, all statements regarding the expected financial impact of the integration of acquisitions, adoption of updated accounting standards and any expected effects of such adoption, restructuring plans and expected associated costs and benefits, intent to repurchase shares of Common Stock, and change in operating results, anticipated market conditions and productivity initiatives are forward looking. Forward-looking statements may be identified by the use of words, such as “believe”, “expect”, “anticipate”, “intend”, “depend”, “should”, “plan”, “estimated”, “predict”, “could”, “may”, “subject to”, “continues”, “growing”, “prospective”, “forecast”, “projected”, “purport”, “might”, “if”, “contemplate”, “potential”, “pending,” “target”, “goals”, “scheduled”, “will likely be”, and similar words and phrases. Discussions of strategies, plans or intentions often contain forward-looking statements. Important factors, among others, that could cause our actual results and future actions to differ materially from those described in forward-looking statements include, but are not limited to:
| • | Changes in demand for our products, market conditions, product quality, or product availability adversely affecting sales levels. |
| • | Changes in markets or competition adversely affecting realization of price increases. |
| • | Failure to achieve projected levels of efficiencies, cost savings and cost reduction measures, including those expected as a result of our lean initiative and strategic sourcing plans. |
| • | The expected benefits and the timing of other actions in connection with our Enterprise Resource Planning ("ERP") system. |
| • | The ability to effectively implement ERP systems without disrupting operational and financial processes. |
| • | Availability and costs of raw materials, purchased components, energy and freight. |
| • | Changes in expected or future levels of operating cash flow, indebtedness and capital spending. |
| • | General economic and business conditions in particular industries, markets or geographic regions, as well as inflationary trends. |
| • | Impacts of trade tariffs, import quotas or other trade restrictions or measures taken by the U.S., U.K., and other countries. |
| • | Regulatory issues, changes in tax laws including the TCJA, or changes in geographic profit mix affecting tax rates and availability of tax incentives. |
| • | A major disruption in one or more of our manufacturing or distribution facilities or headquarters, including the impact of plant consolidations and relocations. |
| • | Changes in our relationships with, or the financial condition or performance of, key distributors and other customers, agents or business partners which could adversely affect our results of operations. |
| • | Impact of productivity improvements on lead times, quality and delivery of product. |
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| • | Anticipated future contributions and assumptions including changes in interest rates and plan assets with respect to pensions and other retirement benefits. |
| • | Adjustments to product warranty accruals in response to claims incurred, historical experiences and known costs. |
| • | Unexpected costs or charges, certain of which might be outside of our control. |
| • | Changes in strategy, economic conditions or other conditions outside of our control affecting anticipated future global product sourcing levels. |
| • | Ability to carry out future acquisitions and strategic investments in our core businesses as well as the acquisition related costs. |
| • | Ability to successfully execute, manage and integrate key acquisitions and mergers. |
| • | Unanticipated difficulties integrating acquisitions as well as the realization of expected synergies and benefits anticipated when we first enter into a transaction. |
| • | The ability of governments to meet their financial obligations. |
| • | Political unrest in foreign countries. |
| • | The impact of Brexit and other world economic and political issues. |
| • | Natural disasters. |
| • | Failure of information technology systems or security breaches resulting in unauthorized disclosure of confidential information. |
| • | Future revisions to or clarifications of the TCJA. |
| • | Future repurchases of common stock under our common stock repurchase program. |
| • | Changes in accounting principles, interpretations, or estimates. |
| • | The outcome of environmental, legal and tax contingencies or costs compared to amounts provided for such contingencies. |
| • | Adverse changes in foreign currency exchange rates and the potential use of hedging instruments to hedge the exposure to fluctuating rates of foreign currency exchange on inventory purchases. |
| • | Transitioning from LIBOR to a replacement alternative reference rate. |
| • | Other factors described in our Securities and Exchange Commission filings, including the “Business”, “Risk Factors” and “Quantitative and Qualitative Disclosures about Market Risk” sections in this Company’s Annual Report on Form 10-K for the year ended December 31, 2019. |
Any such forward-looking statements are not guarantees of future performances and actual results, developments and business decisions may differ from those contemplated by such forward-looking statements. The Company disclaims any duty to update any forward-looking statement, all of which are expressly qualified by the foregoing, other than as required by law.
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