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.
(dollars in millions, except per-share amounts; shipments in thousands of metric tons [kmt])
Overview
Our Business
Arconic (“Arconic” or the “Company”) is a global leader in lightweight metals engineering and manufacturing. Arconic’s innovative, multi-material products, which include aluminum, titanium, and nickel, are used worldwide in aerospace, automotive, commercial transportation, building and construction, industrial applications, defense, and packaging.
Arconic is a global company operating in 18 countries. Based upon the country where the point of sale occurred, the United States and Europe generated 65% and 24%, respectively, of Arconic’s sales in 2018. In addition, Arconic has operating activities in Brazil, Canada, China, Japan, and Russia, among others. Governmental policies, laws and regulations, and other economic factors, including inflation and fluctuations in foreign currency exchange rates and interest rates, affect the results of operations in these countries.
Management Review of 2018 and Outlook for the Future
In 2018, Arconic’s revenues increased 8% over 2017 as a result of higher volumes across all segments including strong volume growth in aerospace engines and defense, automotive, commercial transportation, industrial, and building and construction end markets; higher aluminum pricing and favorable product mix primarily impacting the Global Rolled Products segment; and favorable foreign currency movements; partially offset by a decline in volumes in the industrial gas turbine end market; lower sales of $90 from the divestiture of the Latin America extrusions business (divested in April 2018), $54 from the divestiture of the rolling mill in Fusina, Italy (divested in March 2017), and $46 from the ramp down of Arconic's North American packaging operations (completed in December 2018); and costs of $38 in 2018 related to settlements of certain customer claims primarily related to product introductions. In the segments, Segment operating profit decreased 6% from 2017 as volume growth was more than offset by performance shortfalls in the disks operations, manufacturing inefficiencies in the Engineered Structures business, unfavorable product mix, and higher aluminum prices.
Net income was $642 in 2018 compared to a Net loss of $74 in 2017. There were several significant items that impacted the fourth quarter of 2018. The Company recognized proceeds of approximately $300 in cash and recorded a gain of $119 ($154 pre-tax) on the sale of the Texarkana rolling mill. The Company recorded a loss of $39 ($43 pre-tax) on the sale of the Eger, Hungary forgings business. The Company also recorded a charge of $72 ($92 pre-tax) for pension plan settlement charges associated with significant lump sum payments made to participants. Additionally, the Company recorded several discrete tax items, including benefits related to the reversal of a foreign deferred tax liability of $74 as well as the release of valuation allowances and revaluation of deferred taxes.
Management continued its focus on liquidity and cash flows as well as improving its operating performance through cost reductions, streamlined organizational structures, margin enhancement, and profitable revenue generation. Management has continued its intensified focus on capital efficiency. This focus and the related results enabled Arconic to end 2018 with a solid financial position.
The following financial information reflects certain key measures of Arconic’s 2018 results:
| • | Sales of $14,014, up 8% from 2017, with growth from all segments as key end markets remained healthy, and Net income of $642, or $1.30 per diluted share; |
| • | Total segment operating profit of $1,581, a decrease of $97, or 6%, from 20171; |
| • | Cash provided from operations of $217, cash used for financing activities of $649, and cash provided from investing activities of $565, reflecting improvements in working capital; |
| • | Cash on hand at the end of the year of $2,277; and |
| • | Total debt of $6,330, a decrease in total debt of $514 from 2017. |
(1) For the reconciliation of Total segment operating profit to Consolidated income before income taxes and related information, see page 43.
On January 22, 2019, the Company announced that its Board of Directors (the Board) had determined to no longer pursue a potential sale of Arconic as part of its strategy and portfolio review. Management and the Board have been conducting a rigorous and comprehensive strategy and portfolio review over the past year and as part of that process had considered a sale of the Company, among other matters. However, the Company did not receive a proposal for a full-Company transaction that management and the Board believed would be in the best interest of Arconic’s shareholders and other stakeholders. Management and the Board remain confident in Arconic’s significant potential and are strongly focused on enhancing value for shareholders, through continued operational improvements and through other potential initiatives which have been previously identified in the strategy and portfolio review. The Company has announced the following key initiatives as part of its ongoing
strategy and portfolio review:
| • | Commenced plans to reduce operating costs by approximately $200 on an annual run-rate basis, designed to maximize the impact in 2019; |
| • | Announced the planned separation of its portfolio into Engineered Products and Forgings and Global Rolled Products, with a spin-off of one of the businesses; |
| • | Considering the potential sale of businesses that do not best fit into one of the two segments above; |
| • | Intends to execute its previously authorized $500 share repurchase program in the first half of 2019; |
| • | The Board also authorized an additional $500 of share repurchases, effective through the end of 2020; and |
| • | Expects to reduce its quarterly common stock dividend from $0.06 to $0.02 per share. |
On February 6, 2019, the Company announced that the Board appointed John C. Plant, current Chairman of the Board, as Chairman and Chief Executive Officer of the Company, effective February 6, 2019, to succeed Chip Blankenship, who ceased to serve as Chief Executive Officer of the Company and resigned as a member of the Board, in each case as of that date. In addition, the Company announced that the Board appointed Elmer L. Doty, current member of the Board, as President and Chief Operating Officer, a newly created position, effective February 6, 2019. Mr. Doty will remain a member of the Board. The Company also announced that Arthur D. Collins, Jr., current member of the Board, has been appointed interim Lead Independent Director of the Company, effective February 6, 2019.
On February 19, 2019, the Company entered into an accelerated share repurchase (“ASR”) agreement with JPMorgan Chase Bank to repurchase $700 of its common stock, pursuant to the share repurchase program previously authorized by the Board. Under the ASR agreement, Arconic will receive initial delivery of approximately 32 million shares on February 21, 2019. The final number of shares to be repurchased will be based on the volume-weighted average price of Arconic’s common stock during the term of the transaction, less a discount. The ASR agreement is expected to be completed during the first half of 2019.
The Company will evaluate its organizational structure in conjunction with the planned separation of its portfolio and changes to its reportable segments are expected in the first half of 2019.
In 2019, management projects that sales will be up approximately 2% to 4% supported by increases in most of the Company’s key end markets, as robust growth and the Company’s unique position in those markets is expected to continue. These increases will be partly offset by the expected decline in aluminum prices in 2019 compared with 2018. Earnings per share is expected to grow as management continues to focus on operational performance and driving further cost reductions. The Company expects favorable impacts from volume, net cost savings, aerospace pricing, and lower aluminum pricing, which will be pressured by the continuation of new product introductions in aerospace as well as higher transportation costs and aluminum scrap spreads. Cash flows are expected to keep pace for the full year in 2019 compared with 2018, resulting from improved operating performance and the focus on capital efficiency that is expected to drive lower capital expenditures. Cash flows in the first quarter of 2019 are expected to reflect the typical use of cash based on anticipated timing of working capital increases and interest payments.
2016 Separation Transaction. On November 1, 2016, the Company completed the separation of its business into two standalone, publicly-traded companies, Arconic Inc. and Alcoa Corporation. Following the Separation Transaction, Arconic comprises the Global Rolled Products (other than the rolling mill in Warrick, Indiana, and the 25.1% equity ownership stake in the Ma’aden Rolling Company), the Engineered Products and Solutions, and the Transportation and Construction Solutions segments. Alcoa Corporation comprises the Alumina and Primary Metals segments, the rolling mill in Warrick, Indiana, and the 25.1% equity ownership stake in the Ma’aden Rolling Company in Saudi Arabia.
The Separation Transaction was effected by the distribution of 80.1% of the outstanding shares of Alcoa Corporation common stock to the Company’s shareholders (the “Distribution”). The Company’s shareholders of record as of the close of business on October 20, 2016 (the “Record Date”) received one share of Alcoa Corporation common stock for every three shares of the Company’s common stock held as of the Record Date. The Company distributed 146,159,428 shares of common stock of Alcoa Corporation in the Distribution and retained 36,311,767 shares, or approximately 19.9% (see disposition of retained shares under Results of Operations below), of the common stock of Alcoa Corporation immediately following the Distribution. As a result of the Distribution, Alcoa Corporation is now an independent public company trading under the symbol “AA” on the New York Stock Exchange, and the Company trades under the symbol “ARNC” on the New York Stock Exchange.
On October 31, 2016, Arconic entered into several agreements with Alcoa Corporation that govern the relationship of the parties following the completion of the Separation Transaction. These agreements include the following: Separation and Distribution Agreement, Transition Services Agreement, Tax Matters Agreement, Employee Matters Agreement, Alcoa Corporation to Arconic Inc. Patent, Know-How, and Trade Secret License Agreement, Arconic Inc. to Alcoa Corporation Patent, Know-How, and Trade Secret License Agreement, Alcoa Corporation to Arconic Inc. Trademark License Agreement, Toll Processing and Services Agreement, Master Agreement for the Supply of Primary Aluminum, Massena Lease and
Operations Agreement, Fusina Lease and Operations Agreement, and Stockholder and Registration Rights Agreement. The Toll Processing and Services Agreement expired by its terms at the end of 2018.
Results of Operations
Earnings Summary
Sales. Sales for 2018 were $14,014 compared with $12,960 in 2017, an increase of $1,054, or 8%. The increase was the result of strong volume growth across all segments, primarily in the aerospace engines and defense, automotive, commercial transportation, industrial, and building and construction end markets; higher aluminum prices and favorable product mix primarily in the Global Rolled Products segment; and favorable foreign currency movements; partially offset by a decline in volumes in the industrial gas turbine end market; lower sales of $190 from the divestitures of the Latin America extrusions business (divested in April 2018), the rolling mill in Fusina, Italy (divested in March 2017), and the ramp down of Arconic's North American packaging operations (completed in December 2018); and costs of $38 in 2018 related to settlements of certain customer claims primarily related to product introductions.
Sales for 2017 were $12,960 compared with $12,394 in 2016, an increase of $566, or 5%. The increase was the result of strong volume growth in all segments and higher aluminum pricing, partially offset by the planned ramp down and Toll Processing Agreement relating to the Company’s North America packaging business in Tennessee in the Global Rolled Products segment, as well as unfavorable product pricing in both the Engineered Products and Solutions and Global Rolled Products segments. Pursuant to the Toll Processing Agreement that Arconic entered into with Alcoa Corporation on October 31, 2016 in connection with the Separation Transaction, Arconic provides can body stock to Alcoa Corporation using aluminum supplied by Alcoa Corporation, resulting in the absence of metal sales in 2017 compared to 2016.
Cost of Goods Sold (COGS). COGS as a percentage of Sales was 81.3% in 2018 compared with 78.9% in 2017. The increase was the result of higher aluminum prices; unfavorable aerospace product mix; higher transportation costs; manufacturing inefficiencies in the Engineered Structures business; performance shortfalls in the disks operations; costs related to settlements of certain customer claims noted above; and the impact of a $23 charge related to a physical inventory adjustment at one plant in the Engineered Products and Solutions segment that was recorded in the second quarter of 2018. While a portion of this charge for the physical inventory adjustment related to prior years, the majority related to the first half of 2018. The out-of-period amounts were not material to any interim or annual periods.
COGS as a percentage of Sales was 78.9% in 2017 compared with 78.2% in 2016. The increase was primarily attributable to cost increases, including net higher aluminum prices of $84 and ramp-up costs related to new commercial aerospace engines, and a lower margin product mix, partially offset by net cost savings.
Selling, General Administrative, and Other Expenses (SG&A). SG&A expenses were $604, or 4.3% of Sales, in 2018 compared with $715, or 5.5% of Sales, in 2017. The decrease in SG&A was the result of proxy, advisory and governance-related costs of $58, costs related to the separation of Alcoa Inc. of $18, and costs associated with the Company’s Delaware reincorporation of $3 in 2017, none of which recurred in 2018. Additionally, lower expenses driven by lower annual incentive compensation accruals and overhead cost reductions were somewhat offset by an increase in legal and other advisory costs related to Grenfell Tower of $4 as well as strategy and portfolio review costs of $7 in 2018.
SG&A expenses were $715, or 5.5% of Sales, in 2017 compared with $924, or 7.5% of Sales, in 2016. The decrease in SG&A was the result of expenses related to the Separation Transaction of $193 in 2016 compared to $18 in 2017, as well as ongoing overhead cost reduction efforts, partially offset by proxy, advisory and governance-related costs of $58, external legal and other advisory costs related to Grenfell Tower of $14, and costs associated with the Company’s Delaware reincorporation of $3 in 2017.
Research and Development Expenses (R&D). R&D expenses were $103 in 2018 compared with $109 in 2017 and $130 in 2016. The decrease in both periods was the result of lower spending.
Provision for Depreciation and Amortization (D&A). The provision for D&A was $576 in 2018 compared with $551 in 2017 and $535 in 2016. The increase in both periods was primarily due to capital projects placed into service.
Impairment of Goodwill. In 2017, the Company recognized an impairment of goodwill of $719 related to the annual impairment review of the Arconic Forgings and Extrusions business (see Goodwill under Critical Accounting Policies and Estimates below).
Restructuring and Other Charges. Restructuring and other charges were $9 in 2018 compared with $165 in 2017. The decrease of $156 was primarily due to the gain on the sale of the Texarkana rolling mill of $154, lower layoff costs, and a postretirement curtailment benefit of $28, partially offset by pension plan settlement charges of $96 associated with significant lump sum payments made to participants, a loss on the sale of the Eger, Hungary forgings business of $43, and pension curtailment charges of $23. In 2017, the Company recorded a loss on the sale of the Fusina, Italy rolling mill of $60 and a charge for the impairment of assets associated with the sale of the Latin America extrusions business of $41. See Note T to the
to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K.
Restructuring and other charges were $165 in 2017 compared with $155 in 2016. The increase of $10 was primarily due to a loss of $60 on the sale of the Fusina, Italy rolling mill and a charge of $41 for the impairment of assets associated with the sale of the Latin America extrusions business (divested in 2018) in 2017, partially offset by $57 for costs related to the exit of certain legacy Firth Rixson operations in the U.K. and $37 for exit costs related to the decision in 2016 to permanently shut down a can sheet facility. See Note T to the to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K.
Interest Expense. Interest expense was $378 in 2018 compared with $496 in 2017. The decrease of $118, or 24%, was the result of higher costs incurred in 2017 related to the early redemption of the Company’s outstanding debt than were incurred during 2018, as well as lower debt outstanding.
Interest expense was $496 in 2017 compared with $499 in 2016. The decrease of $3, or 1%, was primarily due to lower interest expense resulting from lower outstanding debt, mostly offset by $73 primarily in higher premiums paid in 2017 related to the early redemption of $1,250 in debt. In the second quarter of 2017, Arconic redeemed all of the Company’s 6.50% Bonds due 2018 and 6.75% Notes due 2018, and a portion of the Company’s 5.72% Notes due 2019 in advance of the respective maturity dates.
Other Expense (Income), Net. Other expense, net was $79 in 2018 compared with Other income, net of $486 in 2017. The decrease in other income, net of $565 was the result of gains recorded during 2017 related to the sale of a portion of Arconic’s investment in Alcoa Corporation common stock of $351, the Debt-for-Equity Exchange (in April and May 2017, the Company acquired a portion of its outstanding notes held by two investment banks (the “Investment Banks”) in exchange for cash and the Company’s remaining 12,958,767 shares (valued at $35.91 per share) in Alcoa Corporation stock and recorded a gain of $167), income of $81 associated with an adjustment to the contingent earn-out liability related to the Firth Rixson acquisition (see Note T to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K), and income of $25 due to the reversal of a liability associated with a separation-related guarantee, none of which recurred in 2018, and unfavorable foreign currency movements, somewhat offset by lower non-service related net periodic benefit cost and the benefit of $29 from establishing a tax indemnification receivable reflecting Alcoa Corporation’s 49% share of a Spanish tax reserve (see Note U to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K).
Other income, net was $486 in 2017 compared with Other expense, net of $41 in 2016. The increase in other income, net of $527 was primarily due to the gain on the sale of a portion of Arconic’s investment in Alcoa Corporation common stock of $351 (in February 2017, the Company sold 23,353,000 shares of Alcoa Corporation stock at $38.03 per share, which resulted in cash proceeds of $888 and a gain of $351) and the gain of $167 on the Debt-for-Equity Exchange, income of $25 associated with a higher reversal of a contingent earn-out liability related to the Firth Rixson acquisition (see Note T to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K), and income of $25 due to the reversal of a liability associated with a separation-related guarantee. The Company was required to provide a guarantee for an Alcoa Corporation electricity contract in the event of an Alcoa Corporation payment default. In the fourth quarter of 2017, Alcoa Corporation announced that it had terminated the electricity contract at its Rockdale Operations and, as a result, Arconic reversed its associated guarantee liability.
Income Taxes. Arconic’s effective tax rate was 26.0% in 2018 compared with the U.S. federal statutory rate of 21%. The effective tax rate differs from the U.S. federal statutory rate primarily as a result of a $60 charge to establish a tax reserve in Spain, a $59 net charge resulting from the Company’s finalized analysis of the U.S. Tax Cuts and Jobs Acts of 2017 ("the 2017 Act"), a $13 charge for U.S. state taxes, foreign income taxed in higher rate jurisdictions, and foreign losses with no tax benefit, partially offset by a $74 benefit related to the reversal of a foreign recapture obligation, a $38 benefit to reverse a foreign tax reserve that is effectively settled, and a $10 benefit for the release of U.S. valuation allowances.
Arconic’s effective tax rate was 115.7% in 2017 compared with the U.S. federal statutory rate of 35%. The effective tax rate differs from the U.S. federal statutory rate primarily as a result of a $719 impairment of goodwill, a $41 impairment of assets in the Latin America extrusions business, and a $60 charge related to the sale of a rolling mill in Italy that are nondeductible for income tax purposes, a $272 tax charge as a provisional impact of the 2017 Act, and a $23 tax charge for an increase in an uncertain tax position in Germany, partially offset by a $73 tax benefit related to the sale and Debt-for-Equity Exchange of the Alcoa Corporation stock, a $69 tax benefit for the release of U.S. state valuation allowances net of the federal tax benefit, a $27 favorable tax impact associated with a non-taxable earn-out liability adjustment in connection with the Firth Rixson acquisition, and by foreign income taxed in lower rate jurisdictions.
Arconic’s effective tax rate was 356.5% in 2016 compared with the U.S. federal statutory rate of 35%. The effective tax rate differs from the U.S. federal statutory rate primarily due to a $1,267 discrete income tax charge for valuation allowances related to the Separation Transaction (see Note H to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K), a $95 tax charge associated with the redemption of company-owned life insurance
policies whose tax basis was less than the redemption amount resulting in a taxable gain, a $51 net charge for the remeasurement of certain deferred tax assets and liabilities due to tax rate and tax law changes, and a $34 unfavorable tax impact related to certain separation costs which are nondeductible for income tax purposes, somewhat offset by a $39 discrete income tax benefit for the release of valuation allowances in Canada and Russia, a $38 tax benefit related to currency impacts of a distribution of previously taxed income, and a $26 favorable tax impact associated with non-taxable settlement proceeds and earn-out liability adjustments in connection with the Firth Rixson acquisition.
Management anticipates that the effective tax rate in 2019 will be between 26.5% and 28.5%. However, business portfolio actions, changes in the current economic environment, tax legislation or rate changes, currency fluctuations, ability to realize deferred tax assets, movements in stock price impacting tax benefits or deficiencies on stock-based payment awards, and the results of operations in certain taxing jurisdictions may cause this estimated rate to fluctuate.
Income (Loss) From Continuing Operations After Income Taxes. Income from continuing operations after income taxes was $642 for 2018, or $1.30 per diluted share, compared to a loss from continuing operations after income taxes of $74 for 2017, or $0.28 per share. The increase in results of $716 was due in part to the following items that occurred in 2017 but did not recur in 2018: a charge for goodwill impairment of $719 ($719 pre-tax); gains related to the sale of a portion of Arconic’s investment in Alcoa Corporation common stock and the Debt-for-Equity Exchange of $405 ($518 pre-tax); and favorable adjustments of $97 ($106 pre-tax) to contingent earn-out and guarantee liabilities as noted below. Additional favorable impacts in 2018 included: volume growth across all segments; lower SG&A expenses due to proxy and separation costs incurred in 2017 and not recurring in 2018, as well as lower incentive compensation accruals; lower Restructuring and other charges driven primarily by the gain on sale of the Texarkana rolling mill, offset by pension settlement charges and the loss on sale of the Eger, Hungary forgings business; lower Interest expense due to lower debt levels; lower pension expenses; and lower Income taxes. These favorable impacts were partially offset by unfavorable aerospace product mix, higher aluminum prices, manufacturing inefficiencies in the Engineered Structures business, performance shortfalls in the disks operations, settlements of certain customer claims, and an unfavorable physical inventory adjustment at one plant.
Loss from continuing operations after income taxes was $74 for 2017, or $0.28 per diluted share, compared with $1,062 for 2016, or $2.58 per share. The increase in results of $988 was primarily attributable to charges for tax valuation allowances and costs related to the Separation Transaction in 2016; a gain of $238 ($351 pre-tax) on the sale of a portion of Arconic’s investment in Alcoa Corporation common stock and a gain of $167 ($167 pre-tax) on the Debt-for-Equity Exchange in 2017; income of $25 ($25 pre-tax) associated with a higher reversal of a contingent earn-out liability related to the Firth Rixson acquisition and income of $16 ($25 pre-tax) due to the reversal of a liability associated with a separation-related guarantee; net cost savings; and higher sales volumes across all segments; partially offset by a charge for goodwill impairment of $719 ($719 pre-tax); a charge related to the 2017 Act of $272; $47 ($73 pre-tax) of higher premiums paid for the early redemption of debt in 2017; higher LIFO inventory expense associated with higher aluminum prices; charges for asset impairments of the Fusina, Italy rolling mill of $60 ($60 pre-tax) and Latin America extrusions business of $41 ($41 pre-tax) based on the sale of these businesses; unfavorable product pricing, primarily in aerospace; and lower-margin product mix.
Segment Information
Arconic’s operations consist of three worldwide reportable segments: Engineered Products and Solutions, Global Rolled Products and Transportation and Construction Solutions (see below). In the first quarter of 2018, the Company changed its primary measure of segment performance from Adjusted earnings before interest, tax, depreciation, and amortization (“Adjusted EBITDA”) to Segment operating profit, which more closely aligns segment performance with Operating income as presented in the Statement of Consolidated Operations. Segment performance under Arconic’s management reporting system is evaluated based on a number of factors; however, the primary measure of performance is Segment operating profit. Arconic’s definition of Segment operating profit is Operating income excluding Special items. Special items include Restructuring and other charges and Impairment of goodwill. Segment operating profit also includes certain items that, under the previous segment performance measure, were recorded in Corporate, such as the impact of LIFO inventory accounting, metal price lag, intersegment profit eliminations, and derivative activities. Segment operating profit may not be comparable to similarly titled measures of other companies. Differences between segment totals and consolidated Arconic are in Corporate. Prior period financial information has been recast to conform to current year presentation.
Segment operating profit for all reportable segments totaled $1,581 in 2018, $1,678 in 2017, and $1,622 in 2016. The following information provides Sales and Segment operating profit for each reportable segment, as well as certain shipment data for Global Rolled Products, for each of the three years in the period ended December 31, 2018. See Note C to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K.
Engineered Products and Solutions
| 2018 | 2017 | 2016 | |||||||||
| Third-party sales | $ | 6,316 | $ | 5,943 | $ | 5,728 | |||||
| Segment operating profit | $ | 891 | $ | 964 | $ | 955 |
The Engineered Products and Solutions segment produces products that are used primarily in the aerospace (commercial and defense), industrial, commercial transportation, and power generation end markets. Such products include fastening systems (titanium, steel, and nickel superalloys); seamless rolled rings (mostly nickel superalloys); investment castings (nickel superalloys, titanium, and aluminum), including airfoils and forged jet engine components (e.g., jet engine disks), and extruded, machined and formed aircraft parts (titanium and aluminum), all of which are sold directly to customers and through distributors. More than 75% of the third-party sales in this segment are from the aerospace end market. A small part of this segment also produces various forged, extruded, and machined metal products (titanium, aluminum and steel) for the oil and gas, automotive, and land and sea defense end markets. Seasonal decreases in sales are generally experienced in the third quarter of the year due to the European summer slowdown across all end markets. Generally, the sales and costs and expenses of this segment are transacted in the local currency of the respective operations, which are mostly the U.S. dollar, British pound and the euro.
On December 31, 2018, as part of the Company’s ongoing strategy and portfolio review, Arconic completed the sale of its Eger, Hungary forgings business that manufactured high volume steel forgings for drivetrain components in the European heavy-duty truck and automotive market. This business generated third-party sales of $32, $38, and $29 in 2018, 2017, and 2016, respectively, and had 180 employees at the time of the divestiture. See Restructuring and other charges under Results of Operations above.
In April 2016, Arconic completed the sale of the Remmele Medical business (that was part of the RTI International Metals Inc. (RTI) acquisition) that manufactured precision-machined metal products for customers in the minimally invasive surgical device and implantable device markets. Remmele Medical generated third-party sales of $23 from January 1, 2016 through the divestiture date, and, at the time of the divestiture, had approximately 330 employees.
Third-party sales for the Engineered Products and Solutions segment increased $373, or 6%, in 2018 compared with 2017, primarily attributable to higher volumes in the aerospace engines and defense end markets and favorable foreign currency movements, partially offset by a decline in volumes in the industrial gas turbine market and lower aerospace pricing principally in the fasteners business.
Third-party sales for this segment increased $215, or 4%, in 2017 compared with 2016, primarily attributable to volume growth in both aerospace engines and airframes, partially offset by lower product pricing, primarily in the aerospace end market, and the absence of sales of $23 related to the Remmele Medical business, which was sold in April 2016.
Segment operating profit for the Engineered Products and Solutions segment decreased $73, or 8%, in 2018 compared with 2017, primarily attributable to performance shortfalls in the disks operations; manufacturing inefficiencies in the Engineered Structures business, including the now resolved forging press outage at the Cleveland facility that impacted the fourth quarter of 2018 with higher costs of $10; unfavorable aerospace engine mix and new product introductions; a physical inventory adjustment of $23; and lower aerospace pricing principally in the fasteners business; partly offset by the strength in aerospace engine and defense volumes.
Segment operating profit for this segment increased $9, or 1%, in 2017 compared with 2016, primarily on higher volumes and net cost savings, partially offset by product pricing pressures, ramp up costs associated with increasing production volumes of new aerospace engine parts, and a lower margin product mix.
In 2019, demand in the commercial aerospace end market is expected to remain strong, driven by the ramp-up of new aerospace engine platforms. Demand in the defense end market is expected to grow due to the continuing ramp-up of certain aerospace programs, while declines in the industrial gas turbine market are expected to continue, albeit at lower levels than in 2018. Net cost savings and favorable pricing are expected.
Global Rolled Products(1)
| 2018 | 2017 | 2016 | |||||||||
| Third-party sales | $ | 5,604 | $ | 5,000 | $ | 4,865 | |||||
| Intersegment sales | 160 | 148 | 118 | ||||||||
| Total sales | $ | 5,764 | $ | 5,148 | $ | 4,983 | |||||
| Segment operating profit | $ | 386 | $ | 424 | $ | 421 | |||||
| Third-party aluminum shipments (kmt) | 1,249 | 1,197 | 1,339 |
| (1) | Excludes the Warrick, IN rolling operations and the equity interest in the rolling mill at the joint venture in Saudi Arabia, both of which were previously part of the Global Rolled Products segment but became part of Alcoa Corporation effective November 1, 2016. |
The Global Rolled Products segment produces aluminum sheet and plate for a variety of end markets. Sheet and plate is sold directly to customers and through distributors related to the aerospace, automotive, commercial transportation, packaging, building and construction, and industrial products (mainly used in the production of machinery and equipment and consumer durables) end markets. A small portion of this segment also produces aseptic foil for the packaging end market. While the customer base for flat-rolled products is large, a significant amount of sales of sheet and plate is to a relatively small number of customers. Generally, the sales and costs and expenses of this segment are transacted in the local currency of the respective operations, which are mostly the U.S. dollar, Chinese yuan, the euro, the Russian ruble, the Brazilian real, and the British pound.
On April 6, 2018, the U.S. Treasury Department’s Office of Foreign Asset Control (“OFAC”) announced new sanctions against Russian “oligarchs” and extended those sanctions to companies that are majority-owned or substantively controlled by those oligarchs. These sanctions block U.S. persons - both individuals and companies - from engaging in transactions with listed oligarchs and their companies. These sanctions originally extended to UC Rusal PLC (“Rusal”), which supplies primary aluminum to Arconic in Europe, the United States, and to the Company’s Samara plant in Russia. The Company operated under a series of temporary licenses issued by OFAC until January 27, 2019 when OFAC removed Rusal from the list of sanctioned parties. The Company complies with and expects to continue to comply with all other aspects of these sanctions and we do not anticipate any interruption in Samara’s ability to operate normally.
In March 2017, Arconic completed the sale of its Fusina, Italy rolling mill. The rolling mill generated third-party sales of $54 and $165 for 2017 and 2016, respectively. At the time of the divestiture, the rolling mill had approximately 312 employees. See Restructuring and other charges under Results of Operations above.
On November 1, 2016, Arconic entered into a Toll Processing Agreement with Alcoa Corporation for the tolling of metal for the Warrick, IN rolling mill which became a part of Alcoa Corporation upon the completion of the Separation Transaction. As part of this arrangement, Arconic provided a toll processing service to Alcoa Corporation to produce can sheet products at its facility in Tennessee through the end date of the contract, December 31, 2018. Alcoa Corporation supplied all required raw materials to Arconic and Arconic processed the raw materials into finished can sheet coils ready for shipment to the end customer. Tolling revenue for 2018, 2017, and the two months ended December 31, 2016 was $144, $190 and $37, respectively.
Third-party sales for the Global Rolled Products segment increased $604, or 12%, in 2018 compared with 2017, primarily attributable to higher aluminum prices; higher volumes in the automotive, commercial transportation, and industrial end markets; and favorable product mix; partially offset by the absence of sales of $54 from the rolling mill in Fusina, Italy (divested in March 2017) and the planned ramp down of Arconic's North American packaging operations (completed in December 2018).
Third-party sales for this segment increased $135, or 3%, in 2017 compared with 2016, primarily attributable to volume growth in the automotive end market and higher aluminum pricing, partially offset by the impact of $362 associated with the ramp-down and Toll Processing Agreement with Alcoa Corporation at the Company’s North America packaging business in Tennessee, the absence of sales of $111 from the rolling mill in Fusina, Italy, aerospace customer inventory destocking and reduced build rates, and pricing pressures in the global packaging market.
Segment operating profit for the Global Rolled Products segment decreased $38, or 9%, in 2018 compared with 2017, primarily driven by unfavorable aerospace wide-body production mix, higher aluminum prices, and higher transportation costs and scrap spreads, partially offset by higher automotive, commercial transportation and industrial volumes. The higher aluminum prices negatively impacted segment operating profit margin by $30, or 100 basis points, in 2018 compared with 2017.
Segment operating profit for this segment increased $3, or 1%, in 2017 compared with 2016, primarily driven by net cost savings and increased automotive volumes, partially offset by lower aerospace volume from customer destocking and reduced build rates, continued pricing pressure on global packaging products and higher aluminum prices. The higher aluminum prices
negatively impacted segment operating profit margin by $37, or 150 basis points, in 2017 compared with 2016.
In 2019, demand in the North America commercial transportation, brazing, and industrial end markets is expected to grow as a result of the International Trade Commission initiated common alloy trade case. Demand in the automotive end market is expected to continue to grow due to the growing demand for innovative products and aluminum-intensive vehicles. Demand from the commercial airframe end market is expected to be flat as the ramp-up of new programs is offset by lower build rates for aluminum intensive wide-body programs. Net productivity improvements are anticipated to continue.
Transportation and Construction Solutions
| 2018 | 2017 | 2016 | |||||||||
| Third-party sales | $ | 2,126 | $ | 2,011 | $ | 1,802 | |||||
| Segment operating profit | $ | 304 | $ | 290 | $ | 246 |
The Transportation and Construction Solutions segment produces products that are used mostly in the commercial transportation and nonresidential building and construction end markets. Such products include integrated aluminum structural systems, architectural extrusions, and forged aluminum commercial vehicle wheels, which are sold both directly to customers and through distributors. A small part of this segment also produces aluminum products for the industrial products end market. Generally, the sales and costs and expenses of this segment are transacted in the local currency of the respective operations, which are primarily the U.S. dollar, the euro, and the Brazilian real.
On July 31, 2018, the Company announced that it had initiated a sale process of its Building and Construction Systems (BCS) business, as part of the Company’s ongoing strategy and portfolio review that commenced in January 2018. BCS generated third-party sales of approximately $1,140, $1,070, and $1,010 for 2018, 2017, and 2016, respectively. The sale process continues to progress. The Company’s decision regarding whether to sell the business will not be finalized until final binding offers are evaluated. Until the Company makes that final decision, the BCS business will remain classified as held and in-use in the Consolidated Financial Statements.
On April 2, 2018, Arconic completed the sale of its Latin America extrusions business as part of its continued drive to streamline its business portfolio, reduce complexity and further focus on its higher-margin products and profitable growth. This business generated sales of $25, $115, and $103 in 2018, 2017, and 2016 respectively, and had 612 employees at the time of the divestiture. See Restructuring and Other Charges under Results of Operations above.
Third-party sales for the Transportation and Construction Solutions segment increased $115, or 6%, in 2018 compared with 2017, primarily driven by higher volumes in the commercial transportation and building and construction end markets, favorable foreign currency movements and higher aluminum prices, partially offset by the absence of sales of $90 resulting from the divestiture of the Latin America extrusions business in April 2018.
Third-party sales for this segment increased $209, or 12%, in 2017 compared with 2016, primarily driven by increased volumes in the commercial transportation and building and construction end markets, higher aluminum pricing, and favorable foreign currency movements, partially offset by lower product pricing.
Segment operating profit for the Transportation and Construction Solutions segment increased $14, or 5%, in 2018 compared with 2017, principally driven by higher volumes in the commercial transportation and building and construction end markets and net cost savings, which more than offset higher aluminum prices. The higher aluminum prices negatively impacted segment operating margin by $57, or 270 basis points, in 2018 compared with 2017.
Segment operating profit for this segment increased $44, or 18%, in 2017 compared with 2016, principally driven by net cost savings and higher volumes, partially offset by lower product pricing in the heavy-duty truck market, unfavorable product mix, and higher aluminum prices. The higher aluminum prices negatively impacted segment operating margin by $8, or 90 basis points, in 2017 compared with 2016.
In 2019, we expect continued growth in the North American and European commercial transportation and building and construction markets and continued demand for innovative products. Net productivity improvements are anticipated to continue.
Reconciliation of Total segment operating profit to Consolidated income from continuing operations before income taxes
| 2018 | 2017 | 2016 | |||||||||
| Total segment operating profit | $ | 1,581 | $ | 1,678 | $ | 1,622 | |||||
| Unallocated amounts: | |||||||||||
| Impairment of goodwill | — | (719 | ) | — | |||||||
| Restructuring and other charges | (9 | ) | (165 | ) | (155 | ) | |||||
| Corporate expense | (247 | ) | (314 | ) | (513 | ) | |||||
| Consolidated operating income | $ | 1,325 | $ | 480 | $ | 954 | |||||
| Interest expense | (378 | ) | (496 | ) | (499 | ) | |||||
| Other (expense) income, net | (79 | ) | 486 | (41 | ) | ||||||
| Consolidated income from continuing operations before income taxes | $ | 868 | $ | 470 | $ | 414 |
See Restructuring and Other Charges, Impairment of Goodwill, Interest Expense, and Other Expense (Income), Net discussions above under Results of Operations for reference.
Corporate expense decreased in 2018 compared with 2017 primarily due to proxy, advisory and governance-related costs of $58 and costs related to the separation of Alcoa Inc. of $18 in 2017, neither of which recurred in 2018. Also, lower expenses driven by lower annual incentive compensation accruals and overhead cost reductions were partially offset by costs incurred in the second quarter of 2018 related to the settlements of certain customer claims primarily related to product introductions of $38, an increase in legal and other advisory costs related to Grenfell Tower of $4, and strategy and portfolio review costs of $7 in 2018.
Corporate expense decreased in 2017 compared with 2016 primarily attributable to costs incurred in 2016 related to the Separation Transaction, partially offset by proxy, advisory and governance-related costs and legal and other advisory costs related to Grenfell Tower incurred in 2017.
Environmental Matters
See the Environmental Matters section of Note U to the Consolidated Financial Statements in Part II, Item 8 of this Form 10-K.
Liquidity and Capital Resources
Arconic maintains a disciplined approach to cash management and strengthening of its balance sheet. Management continued to focus on actions to improve Arconic’s cost structure and liquidity, providing the Company with the ability to operate effectively. Such actions included procurement efficiencies and overhead rationalization to reduce costs, working capital initiatives, and maintaining a sustainable level of capital expenditures.
Cash provided from operations and financing activities is expected to be adequate to cover Arconic’s operational and business needs over the next 12 months. For an analysis of long-term liquidity, see Contractual Obligations and Off-Balance Sheet Arrangements below.
At December 31, 2018, cash and cash equivalents of Arconic were $2,277, of which $541 was held by Arconic's non-U.S. subsidiaries. If the cash held by non-U.S. subsidiaries were to be repatriated to the U.S., the company does not expect there to be additional material income tax consequences.
The Statement of Consolidated Cash Flows has not been restated for discontinued operations, therefore the discussion below concerning Operating Activities, Financing Activities, and Investing Activities for the year ended December 31, 2016 includes the results of both Arconic and Alcoa Corporation up through the completion of the Separation Transaction on November 1, 2016.
Operating Activities
Cash provided from operations in 2018 was $217 compared with cash used for operations of $39 in 2017. The increase of $256 was primarily due to lower working capital of $209 and a favorable change in noncurrent liabilities of $169 due primarily to reversals in 2017 related to the Firth Rixson earn-out liability of $81 and separation-related guarantee liability of $25, partially offset by lower operating results. The components of the change in working capital included favorable changes of $277 in accounts payable, $127 in taxes, including income taxes, and $118 in inventories, partially offset by unfavorable changes of $227 in receivables, $74 in accrued expenses, and $12 in prepaid expenses and other current assets.
Cash used for operations in 2017 was $39 compared with Cash provided from operations $95 in 2016. The decrease of $134 was primarily due to lower operating results and higher pension contributions of $20, partially offset by a favorable change in
noncurrent assets of $111 due to the prepayment of $200 made in April 2016 related to a gas supply agreement for the Australia alumina refineries (Alcoa Corporation), a favorable change in noncurrent liabilities of $55, and lower cash used for working capital of $17. The components of the change in working capital included favorable changes of $101 in receivables; $87 in prepaid expenses and other current assets; and $278 in accrued expenses; mostly offset by unfavorable changes in working capital, including $163 in inventories; $170 in accounts payable, trade; and $116 in taxes, including income taxes.
Financing Activities
Cash used for financing activities was $649 in 2018 compared with $1,015 in 2017 and $757 in 2016.
The use of cash in 2018 was principally the result of $1,103 in repayments on borrowings under certain revolving credit facilities (see below) and repayments on debt, primarily related to the early redemption of the remaining outstanding 5.72% Notes due in 2019 (see Note P to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K) and $119 in dividends to shareholders. These items were partially offset by $600 in additions to debt, primarily from borrowings under certain revolving credit facilities.
The use of cash in 2017 was principally the result of $1,634 in repayments on borrowings under certain revolving credit facilities (see below) and repayments on debt, primarily related to the early redemption of the Company’s 6.50% Bonds due 2018, 6.75% Notes due 2018, and a portion of the 5.72% Notes due 2019 (see Note P to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K); $162 in dividends to shareholders; and $52 in premiums paid on early redemption of debt. These items were partially offset by $816 in additions to debt, primarily from borrowings under certain revolving credit facilities, and $50 of proceeds from the exercise of stock options.
The use of cash in 2016 was principally the result of $2,734 in payments on debt, mostly related to the repayment of borrowings under certain revolving credit facilitates (see below) and the repayment in December 2016 of $750 of outstanding principal of 5.55% Notes due February 2017; $228 in dividends to shareholders; and $175 in net cash paid to noncontrolling interests (Alcoa Corporation). These items were mostly offset by $1,962 in additions to debt, virtually all of which was the result of borrowing under certain revolving credit facilities, and $421 in net cash transferred from Alcoa Corporation at the completion of the Separation Transaction.
In July 2015, through the acquisition of RTI, Arconic assumed the obligation to repay two tranches of convertible debt; one tranche was due and settled in cash on December 1, 2015 (principal amount of $115) and the other tranche is due on October 15, 2019 (principal amount of $403), unless earlier converted or purchased by Arconic at the holder’s option under specific conditions. Upon conversion of the 2019 convertible notes, holders will receive, at Arconic’s election, cash, shares of common stock (approximately 14,453,000 shares using the December 31, 2018 conversion rate of 35.9125 shares per $1,000 (not in millions) bond or per-share conversion price of $27.8455), or a combination of cash and shares. On the maturity date, each holder of outstanding notes will be entitled to receive $1,000 (not in millions) in cash for each $1,000 (not in millions) bond, together with accrued and unpaid interest.
In September 2014, Arconic completed two public securities offerings under its shelf registration statement for (i) $1,250 of 25 million depositary shares, each representing a 1/10th interest in a share of Arconic’s 5.375% Class B Mandatory Convertible Preferred Stock, Series 1, par value $1 per share, liquidation preference $500 per share, and (ii) $1,250 of 5.125% Notes due 2024. The net proceeds of the offerings were used to finance the cash portion of the acquisition of Firth Rixson. On October 2, 2017, all outstanding 24,975,978 depositary shares were converted at a rate of 1.56996 into 39,211,286 common shares; 24,022 depositary shares were previously tendered for early conversion into 31,420 shares of Arconic common stock. No gain or loss was recognized associated with this noncash equity transaction.
Arconic maintains a Five-Year Revolving Credit Agreement (the “Credit Agreement”) with a syndicate of lenders and issuers named therein that expires on June 29, 2023 and provides for a senior unsecured revolving credit facility of $3,000. In addition to the Credit Agreement, Arconic has a number of other credit agreements that provide a combined borrowing capacity of $715 as of December 31, 2018. See Note P to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K.
Arconic’s costs of borrowing and ability to access the capital markets are affected not only by market conditions but also by the short- and long-term debt ratings assigned to Arconic by the major credit rating agencies.
On May 1, 2017, Standard and Poor’s Ratings Services (S&P) affirmed Arconic’s long-term debt at BBB-, an investment grade rating, with a stable outlook, and its short-term debt at A-3. On February 7, 2019, S&P changed the outlook from stable to negative credit watch. On November 1, 2016, Moody’s Investor Service (Moody’s) downgraded Arconic’s long-term debt rating from Ba1, a non-investment grade, to Ba2 and its short-term debt rating from Speculative Grade Liquidity-1 to Speculative Grade Liquidity-2. Additionally, Moody’s changed the outlook from negative to stable (ratings and outlook were affirmed on November 2, 2017 and October 8, 2018). On April 21, 2016, Fitch affirmed Arconic’s long-term debt rating at BB+, a non-investment grade, and short-term debt at B. Additionally, Fitch changed the outlook from positive to evolving. On July 7, 2016, Fitch changed the outlook from evolving to stable (ratings and outlook were affirmed on July 3, 2017). On September
27, 2018, Fitch changed the outlook from stable to positive (ratings and outlook were affirmed on September 27, 2018).
Investing Activities
Cash provided from investing activities was $565 in 2018 compared with $1,320 in 2017 and $591 in 2016.
The source of cash in 2018 included cash receipts from sold receivables of $1,016 and proceeds from the sale of the Texarkana, Texas rolling mill and cast house of $302, partially offset by capital expenditures of $768, including the horizontal heat treat furnace at the Davenport, Iowa plant and an expansion of a wheels plant in Szekesfehervar, Hungary.
The source of cash in 2017 included proceeds of $888 from the sale of a portion of Arconic’s investment in Alcoa Corporation common stock, cash receipts from sold receivables of $792, and the receipt of proceeds from the sale of the Yadkin Hydroelectric Project of $243, somewhat offset by cash used for capital expenditures of $596, including the aerospace expansion (very thick plate stretcher and horizontal heat treat furnace) at the Davenport, Iowa plant and a titanium aluminide furnace at the Niles, Ohio facility, and the injection of $10 into the Fusina rolling business prior to its sale.
The source of cash in 2016 was mainly due to $778 of cash receipts from sold receivables, $692 in proceeds from the sale of assets and businesses, including $457 from the redemption of company-owned life insurance policies, $120 in proceeds related to the sale of the Intalco smelter wharf property (Alcoa Corporation), and $102 in proceeds ($99 net of transaction costs) from the sale of the Remmele Medical business, which was part of Arconic’s acquisition of RTI in July 2015; and $280 in sales of investments, composed primarily of $145 for an equity interest in a natural gas pipeline in Australia (Alcoa Corporation) and $130 for securities held by Arconic’s captive insurance company. These sources of cash were partially offset by $1,125 in capital expenditures ($298 Alcoa Corporation), 29% of which related to growth projects, including the aerospace expansion (very thick plate stretcher) at the Davenport, Iowa plant and a titanium aluminide furnace at the Niles, Ohio facility.
Noncash Financing and Investing Activities
On October 2, 2017, all outstanding 24,975,978 depositary shares (each depositary share representing a 1/10th interest in a share of the mandatory convertible preferred stock) were converted at a rate of 1.56996 into 39,211,286 common shares; 24,022 depositary shares were previously tendered for early conversion into 31,420 shares of Arconic common stock. No gain or loss was recognized associated with this equity transaction. See Note I to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K.
In the second quarter of 2017, the Company completed a Debt-for-Equity Exchange with the Investment Banks for the remaining portion of Arconic’s retained interest in Alcoa Corporation common stock for a portion of the Company’s outstanding notes held by the Investment Banks for $465 including accrued and unpaid interest. See Note P to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K.
On October 5, 2016, Arconic completed a 1-for-3 reverse stock split of its outstanding and authorized shares of common stock, pursuant to the authorization provided at a special meeting of Arconic common shareholders (the “Reverse Stock Split”). The Reverse Stock Split reduced the number of shares of common stock outstanding from approximately 1.3 billion shares to approximately 0.4 billion shares. The par value of the common stock remained at $1.00 per share. Accordingly, Common stock and Additional capital in the Company’s Statement of Changes in Consolidated Equity at December 31, 2016 reflect a decrease and increase of $877, respectively.
In August 2016, Arconic retired its outstanding treasury stock consisting of approximately 76 million shares. As a result, Common stock and Additional capital were decreased by $76 and $2,563, respectively, in the Company’s Statement of Changes in Consolidated Equity at December 31, 2016, to reflect the retirement of the treasury shares.
Contractual Obligations and Off-Balance Sheet Arrangements
Contractual Obligations. Arconic is required to make future payments under various contracts, including long-term purchase obligations, financing arrangements, and lease agreements. Arconic also has commitments to fund its pension plans, provide payments for other postretirement benefit plans, and fund capital projects. As of December 31, 2018, a summary of Arconic’s outstanding contractual obligations is as follows (these contractual obligations are grouped in the same manner as they are classified in the Statement of Consolidated Cash Flows in order to provide a better understanding of the nature of the obligations and to provide a basis for comparison to historical information):
| Total | 2019 | 2020-2021 | 2022-2023 | Thereafter | |||||||||||||||
| Operating activities: | |||||||||||||||||||
| Energy-related purchase obligations | $ | 72 | $ | 37 | $ | 28 | $ | 7 | $ | — | |||||||||
| Raw material purchase obligations | 829 | 652 | 155 | 19 | 3 | ||||||||||||||
| Other purchase obligations | 102 | 81 | 13 | 6 | 2 | ||||||||||||||
| Operating leases | 379 | 94 | 128 | 70 | 87 | ||||||||||||||
| Interest related to total debt | 2,326 | 351 | 592 | 370 | 1,013 | ||||||||||||||
| Estimated minimum required pension funding | 1,860 | 255 | 840 | 765 | — | ||||||||||||||
| Other postretirement benefit payments | 730 | 90 | 170 | 170 | 300 | ||||||||||||||
| Layoff and other restructuring payments | 25 | 19 | 4 | 1 | 1 | ||||||||||||||
| Deferred revenue arrangements | 18 | 12 | 6 | — | — | ||||||||||||||
| Uncertain tax positions | 187 | — | — | — | 187 | ||||||||||||||
| Financing activities: | |||||||||||||||||||
| Total debt | 6,330 | 421 | 2,243 | 623 | 3,043 | ||||||||||||||
| Dividends to shareholders | — | — | — | — | — | ||||||||||||||
| Investing activities: | |||||||||||||||||||
| Capital projects | 665 | 532 | 133 | — | — | ||||||||||||||
| Totals | $ | 13,523 | $ | 2,544 | $ | 4,312 | $ | 2,031 | $ | 4,636 |
Obligations for Operating Activities
Energy-related purchase obligations consist primarily of electricity and natural gas contracts with expiration dates ranging from one year to five years. Raw material purchase obligations consist mostly of aluminum, titanium sponge, and various other metals with expiration dates ranging from less than one year to six years. Many of these purchase obligations contain variable pricing components, and, as a result, actual cash payments may differ from the estimates provided in the preceding table. Operating leases represent multi-year obligations for certain land and buildings, plant equipment, vehicles, and computer equipment.
Interest related to total debt is based on interest rates in effect as of December 31, 2018 and is calculated on debt with maturities that extend to 2042.
Estimated minimum required pension funding and postretirement benefit payments are based on actuarial estimates using current assumptions for discount rates, long-term rate of return on plan assets, rate of compensation increases, and health care cost trend rates, among others. It is Arconic’s policy to fund amounts for pension plans sufficient to meet the minimum requirements set forth in applicable country benefits laws and tax laws. Periodically, Arconic contributes additional amounts as deemed appropriate. In 2018, the Company funded $298, of which $72 was contributed to its U.S. plans in excess of the minimum required under the Employee Retirement Income Security Act (ERISA). The estimates reported in the preceding table include amounts sufficient to meet the minimum required, along with a $34 contribution in 2019 related to an agreement with the Pension Benefit Guaranty Corporation (PBGC) (see Note G to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K). Arconic has determined that it is not practicable to present pension funding and other postretirement benefit payments beyond 2023 and 2028, respectively.
Layoff and other restructuring payments to be paid within one year primarily relate to severance costs, special layoff benefit payments, and lease termination costs, while payments expected to be paid over the next several years relate to lease termination costs.
Deferred revenue arrangements require Arconic to deliver product to a customer over the specified contract period through 2020 for a sheet and plate contract. While these obligations are not expected to result in cash payments, they represent contractual obligations for which the Company would be obligated if the specified product deliveries could not be made.
Uncertain tax positions taken or expected to be taken on an income tax return may result in additional payments to tax authorities. The amount in the preceding table includes interest and penalties accrued related to such positions as of December 31, 2018. The total amount of uncertain tax positions is included in the “Thereafter” column as the Company is not able to reasonably estimate the timing of potential future payments. If a tax authority agrees with the tax position taken or expected to be taken or the applicable statute of limitations expires, then additional payments will not be necessary.
Obligations for Financing Activities
Arconic has historically paid quarterly dividends on its preferred and common stock. Including dividends on preferred stock, Arconic paid $119 in dividends to shareholders during 2018. Because all dividends are subject to approval by Arconic’s Board of Directors, amounts are not included in the preceding table unless such authorization has occurred. As of December 31, 2018, there were 483,270,717 shares of outstanding common stock and 546,024 shares of outstanding Class A preferred stock. In 2018, the annual preferred stock dividend was $3.75 per share and the annual common stock dividend was $0.24 per share.
Obligations for Investing Activities
Capital projects in the preceding table only include amounts approved by management as of December 31, 2018. Funding levels may vary in future years based on anticipated construction schedules of the projects. It is expected that significant expansion projects will be funded through various sources, including cash provided from operations. Total capital expenditures are anticipated to be approximately $700 in 2019.
Off-Balance Sheet Arrangements
At December 31, 2018, Arconic has outstanding bank guarantees related to tax matters, outstanding debt, workers’ compensation, environmental obligations, energy contracts, and customs duties, among others. The total amount committed under these guarantees, which expire at various dates between 2019 and 2026 was $37 at December 31, 2018.
Pursuant to the Separation and Distribution Agreement between Arconic and Alcoa Corporation, Arconic was required to provide certain guarantees for Alcoa Corporation, which had a combined fair value of $6 and $8 at December 31, 2018 and 2017, respectively, and were included in Other noncurrent liabilities and deferred credits on the accompanying Consolidated Balance Sheet. Arconic was required to provide payment guarantees for Alcoa Corporation issued on behalf of a third party related to project financing for Alcoa Corporation’s aluminum complex in Saudi Arabia. During the third quarter of 2018, Arconic was released from this guarantee. Furthermore, Arconic was required to provide guarantees related to two long-term supply agreements for energy for Alcoa Corporation facilities in the event of an Alcoa Corporation payment default. In October 2017, Alcoa Corporation announced that it had terminated one of the two agreements, the electricity contract with Luminant Generation Company LLC that was tied to its Rockdale Operations, effective as of October 1, 2017. As a result of the termination of the Rockdale electricity contract, Arconic recorded income of $25 in the fourth quarter of 2017 associated with reversing the fair value of the electricity contract guarantee. For the remaining long-term supply agreement, Arconic is required to provide a guarantee up to an estimated present value amount of approximately $1,087 and $1,297 at December 31, 2018 and December 31, 2017, respectively, in the event of an Alcoa Corporation payment default. This guarantee expires in 2047. For this guarantee, subject to its provisions, Arconic is secondarily liable in the event of a payment default by Alcoa Corporation. Arconic currently views the risk of an Alcoa Corporation payment default on its obligations under the contract to be remote.
In December 2016, Arconic entered into a one-year claims purchase agreement with a bank covering claims up to $245 related to the Saudi Arabian joint venture and two long-term energy supply agreements. The majority of the premium was paid by Alcoa Corporation. The agreement matured in December 2017 and was not renewed in 2018 due to the decline in exposure to guarantee claims including a substantial reduction in the guarantees related to the Saudi Arabian joint venture and also the elimination of the guarantee related to the Rockdale energy contract. In December 2018, Arconic entered into a one-year insurance policy with a limit of $80 relating to the remaining long-term energy supply agreement. The premium is expected to be paid by Alcoa Corporation. The decision to enter into a claims purchase agreement or insurance policy will be made on an annual basis going forward.
Arconic has outstanding letters of credit primarily related to workers’ compensation, environmental obligations, and leasing obligations. The total amount committed under these letters of credit, which automatically renew or expire at various dates, mostly in 2019, was $136 at December 31, 2018.
Pursuant to the Separation and Distribution Agreement, Arconic was required to retain letters of credit of $54 that had previously been provided related to both Arconic and Alcoa Corporation workers’ compensation claims which occurred prior to November 1, 2016. Alcoa Corporation workers’ compensation claims and letter of credit fees paid by Arconic are being proportionally billed to and are being fully reimbursed by Alcoa Corporation.
Arconic has outstanding surety bonds primarily related to tax matters, contract performance, workers’ compensation, environmental-related matters, and customs duties. The total amount committed under these surety bonds, which expire at various dates, primarily in 2019, was $50 at December 31, 2018.
Pursuant to the Separation and Distribution Agreement, Arconic was required to provide surety bonds related to Alcoa Corporation workers’ compensation claims which occurred prior to November 1, 2016 and, as a result, Arconic has $25 in outstanding surety bonds relating to these liabilities. Alcoa Corporation workers’ compensation claims and surety bond fees paid by Arconic are being proportionally billed to and are being fully reimbursed by Alcoa Corporation.
Critical Accounting Policies and Estimates
The preparation of the Consolidated Financial Statements in accordance with accounting principles generally accepted in the United States of America requires management to make certain judgments, estimates, and assumptions regarding uncertainties that affect the amounts reported in the Consolidated Financial Statements and disclosed in the accompanying Notes. Areas that require significant judgments, estimates, and assumptions include accounting for environmental and litigation matters; the testing of goodwill, other intangible assets, and properties, plants, and equipment for impairment; estimating fair value of businesses acquired or divested; pension plans and other postretirement benefits obligations; stock-based compensation; and income taxes.
Management uses historical experience and all available information to make these judgments, estimates, and assumptions, and actual results may differ from those used to prepare the Company’s Consolidated Financial Statements at any given time. Despite these inherent limitations, management believes that Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and accompanying Notes provide a meaningful and fair perspective of the Company.
A summary of the Company’s significant accounting policies is included in Note A to the Consolidated Financial Statements. Management believes that the application of these policies on a consistent basis enables the Company to provide the users of the Consolidated Financial Statements with useful and reliable information about the Company’s operating results and financial condition.
Environmental Matters. Expenditures for current operations are expensed or capitalized, as appropriate. Expenditures relating to existing conditions caused by past operations, which will not contribute to future revenues, are expensed. Liabilities are recorded when remediation costs are probable and can be reasonably estimated. The liability may include costs such as site investigations, consultant fees, feasibility studies, outside contractors, and monitoring expenses. Estimates are generally not discounted or reduced by potential claims for recovery. Claims for recovery are recognized when probable and as agreements are reached with third parties. The estimates also include costs related to other potentially responsible parties to the extent that Arconic has reason to believe such parties will not fully pay their proportionate share. The liability is continuously reviewed and adjusted to reflect current remediation progress, prospective estimates of required activity, and other factors that may be relevant, including changes in technology or regulations.
Litigation Matters. For asserted claims and assessments, liabilities are recorded when an unfavorable outcome of a matter is deemed to be probable and the loss is reasonably estimable. Management determines the likelihood of an unfavorable outcome based on many factors such as the nature of the matter, available defenses and case strategy, progress of the matter, views and opinions of legal counsel and other advisors, applicability and success of appeals processes, and the outcome of similar historical matters, among others. Once an unfavorable outcome is deemed probable, management weighs the probability of estimated losses, and the most reasonable loss estimate is recorded. If an unfavorable outcome of a matter is deemed to be reasonably possible, then the matter is disclosed and no liability is recorded. With respect to unasserted claims or assessments, management must first determine that the probability that an assertion will be made is likely, then, a determination as to the likelihood of an unfavorable outcome and the ability to reasonably estimate the potential loss is made. Legal matters are reviewed on a continuous basis to determine if there has been a change in management’s judgment regarding the likelihood of an unfavorable outcome or the estimate of a potential loss.
Goodwill. Goodwill is not amortized; instead, it is reviewed for impairment annually (in the fourth quarter) or more frequently if indicators of impairment exist or if a decision is made to sell or realign a business. A significant amount of judgment is involved in determining if an indicator of impairment has occurred. Such indicators may include deterioration in general economic conditions, negative developments in equity and credit markets, adverse changes in the markets in which an entity operates, increases in input costs that have a negative effect on earnings and cash flows, or a trend of negative or declining cash flows over multiple periods, among others. The fair value that could be realized in an actual transaction may differ from that used to evaluate the impairment of goodwill.
Goodwill is allocated among and evaluated for impairment at the reporting unit level, which is defined as an operating segment or one level below an operating segment. Arconic had six reporting units for 2018, of which three were included in the Engineered Products and Solutions segment (Arconic Fastening Systems, Arconic Engines, Arconic Engineered Structures), two were included in the Transportation and Construction Solutions segment (Arconic Wheel and Transportation Products and Building and Construction Systems), and the remaining reporting unit was the Global Rolled Products segment.
In reviewing goodwill for impairment, an entity has the option to first assess qualitative factors to determine whether the
existence of events or circumstances leads to a determination that it is more likely than not (greater than 50%) that the estimated fair value of a reporting unit is less than its carrying amount. If an entity elects to perform a qualitative assessment and determines that an impairment is more likely than not, the entity is then required to perform the quantitative impairment test (described below), otherwise no further analysis is required. An entity also may elect not to perform the qualitative assessment and, instead, proceed directly to the quantitative impairment test. The ultimate outcome of the goodwill impairment review for a reporting unit should be the same whether an entity chooses to perform the qualitative assessment or proceeds directly to the quantitative impairment test.
Arconic determines annually, based on facts and circumstances, which of its reporting units will be subject to the qualitative assessment. For those reporting units where a qualitative assessment is either not performed or for which the conclusion is that an impairment is more likely than not, a quantitative impairment test will be performed. Arconic’s policy is that a quantitative impairment test be performed for each reporting unit at least once during every three-year period.
During the 2018 annual review of goodwill, management proceeded directly to the quantitative impairment test for all six of its reporting units. The estimated fair values for each of the six reporting units exceeded their respective carrying values by more than 25%, thus, there was no goodwill impairment. Under the quantitative impairment test, the evaluation of impairment involves comparing the current fair value of each reporting unit to its carrying value, including goodwill. Arconic uses a discounted cash flow model (DCF) to estimate the current fair value of its reporting units when testing for impairment, as management believes forecasted cash flows are the best indicator of such fair value. A number of significant assumptions and estimates are involved in the application of the DCF model to forecast operating cash flows, including sales growth (volumes and pricing), production costs, capital spending, and discount rate. Most of these assumptions vary significantly among the reporting units. Cash flow forecasts are generally based on approved business unit operating plans for the early years and historical relationships in later years. The WACC rate for the individual reporting units is estimated with the assistance of valuation experts. Arconic would recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value without exceeding the total amount of goodwill allocated to that reporting unit.
Goodwill impairment tests in 2017 and 2016 indicated that goodwill was not impaired for any of the Company’s reporting units, except for the Arconic Forgings and Extrusions (AFE) business whose estimated fair value was lower than its carrying value. As such, Arconic recorded an impairment for the full amount of goodwill in the AFE reporting unit of $719. The decrease in the AFE fair value was primarily due to unfavorable performance that was impacting operating margins and a higher discount rate due to an increase in the risk-free rate of return, while the carrying value increased compared to prior year.
Properties, Plants, and Equipment and Other Intangible Assets. Properties, plants, and equipment and Other intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets (asset group) may not be recoverable. Recoverability of assets is determined by comparing the estimated undiscounted net cash flows of the operations related to the assets (asset group) to their carrying amount. An impairment loss would be recognized when the carrying amount of the assets (asset group) exceeds the estimated undiscounted net cash flows. The amount of the impairment loss to be recorded is calculated as the excess of the carrying value of the assets (asset group) over their fair value, with fair value determined using the best information available, which generally is a DCF model. The determination of what constitutes an asset group, the associated estimated undiscounted net cash flows, and the estimated useful lives of assets also require significant judgments.
In the second quarter of 2018, the Company updated its three-year strategic plan and determined that there was a decline in the forecasted financial performance for the disks operations, an asset group within the AEN business unit. As such, the Company evaluated the recoverability of the long-lived assets by comparing their carrying value of approximately $515 to the estimated undiscounted net cash flows of the disks operations, resulting in an estimated fair value in excess of their carrying value of approximately 13%; thus, there was no impairment. If the disks operations do not achieve the revised forecasted financial performance or if there are changes in any significant assumptions, a material non-cash impairment of long-lived assets may occur in future periods. These significant assumptions include sales growth, cost of raw materials, ramp up of additional production capacity, and working capital. A 1% decrease in the forecasted net cash flows would reduce the undiscounted cash flows by approximately $6. There were no indicators of impairment identified for the disks operations during the third or fourth quarters of 2018 and, as such, the Company did not evaluate the recoverability of its long-lived assets.
Discontinued Operations and Assets Held for Sale. The fair values of all businesses to be divested are estimated using accepted valuation techniques such as a DCF model, valuations performed by third parties, earnings multiples, or indicative bids, when available. A number of significant estimates and assumptions are involved in the application of these techniques, including the forecasting of markets and market share, sales volumes and prices, costs and expenses, and multiple other factors. Management considers historical experience and all available information at the time the estimates are made; however, the fair value that is ultimately realized upon the divestiture of a business may differ from the estimated fair value reflected in the Consolidated Financial Statements.
Pension and Other Postretirement Benefits. Liabilities and expenses for pension and other postretirement benefits are determined using actuarial methodologies and incorporate significant assumptions, including the interest rate used to discount the future estimated liability, the expected long-term rate of return on plan assets, and several assumptions relating to the employee workforce (salary increases, health care cost trend rates, retirement age, and mortality).
The interest rate used to discount future estimated liabilities is determined using a Company-specific yield curve model (above-median) developed with the assistance of an external actuary. The cash flows of the plans’ projected benefit obligations are discounted using a single equivalent rate derived from yields on high quality corporate bonds, which represent a broad diversification of issuers in various sectors, including finance and banking, industrials, transportation, and utilities, among others. The yield curve model parallels the plans’ projected cash flows, which have an average duration of 10 years. The underlying cash flows of the bonds included in the model exceed the cash flows needed to satisfy the Company’s plans’ obligations multiple times. In 2018, 2017, and 2016, the discount rate used to determine benefit obligations for U.S. pension and other postretirement benefit plans was 4.35%, 3.75%, and 4.20%, respectively. The impact on the liabilities of a change in the discount rate of 1/4 of 1% would be approximately $170 and either a charge or credit of approximately $2 to after-tax earnings in the following year.
In conjunction with the annual measurement of the funded status of Arconic’s pension and other postretirement benefit plans at December 31, 2015, management elected to change the manner in which the interest cost component of net periodic benefit cost will be determined in 2016 and beyond. Previously, the interest cost component was determined by multiplying the single equivalent rate described above and the aggregate discounted cash flows of the plans’ projected benefit obligations. Under the new methodology, the interest cost component will be determined by aggregating the product of the discounted cash flows of the plans’ projected benefit obligations for each year and an individual spot rate (referred to as the “spot rate” approach). This change resulted in a lower interest cost component of net periodic benefit cost under the new methodology compared to the previous methodology in 2018, 2017, and 2016 of $24, $34, and $84, respectively, for pension plans and $4, $6, and $14, respectively, for other postretirement benefit plans. Management believes this new methodology, which represents a change in an accounting estimate, is a better measure of the interest cost as each year’s cash flows are specifically linked to the interest rates of bond payments in the same respective year.
The expected long-term rate of return on plan assets is generally applied to a five-year market-related value of plan assets (a fair value at the plan measurement date is used for certain non-U.S. plans). The process used by management to develop this assumption is one that relies on a combination of historical asset return information and forward-looking returns by asset class. As it relates to historical asset return information, management focuses on various historical moving averages when developing this assumption. While consideration is given to recent performance and historical returns, the assumption represents a long-term, prospective return. Management also incorporates expected future returns on current and planned asset allocations using information from various external investment managers and consultants, as well as management’s own judgment.
For 2018, 2017, and 2016, management used 7.00%, 7.75%, and 7.75%, respectively, as its expected long-term rate of return, which was based on the prevailing and planned strategic asset allocations, as well as estimates of future returns by asset class. These rates fell within the respective range of the 20-year moving average of actual performance and the expected future return developed by asset class. For 2019, management anticipates that 7.00% will be the expected long-term rate of return. The decrease of 75 basis points in the 2018 expected long-term rate of return was due to a decrease in the expected return by asset class and the 20-year moving average. A change in the assumption for the expected long-term rate of return on plan assets of 1/4 of 1% would impact after-tax earnings by approximately $10 for 2019.
In 2018, a net loss of $114 (after-tax) was recorded in other comprehensive loss, primarily due to the impact of the adoption of new accounting guidance that permits a reclassification to Accumulated deficit for stranded tax effects resulting from the Tax Cuts and Jobs Act of 2017, as well as the plan asset performance that was less than expected, which were partially offset by the increase in the discount rate of 60 basis points and the amortization of actuarial losses. In 2017, a net loss of $220 (after-tax) was recorded in other comprehensive loss, primarily due to the decrease in the discount rate of 45 basis points and plan asset performance less than expected, which were partially offset by the amortization of actuarial losses. In 2016, a net benefit of $1,601 (after-tax and noncontrolling interest) was recorded in other comprehensive loss, primarily due to the transfer of $2,080 to Alcoa Corporation which was partially offset by a net charge of $479. The charge was due to the unfavorable performance of the plan assets and a 9 basis point decrease in the discount rate, which were partially offset by the amortization of actuarial losses.
Stock-Based Compensation. Arconic recognizes compensation expense for employee equity grants using the non-substantive vesting period approach, in which the expense is recognized ratably over the requisite service period based on the grant date fair value. Forfeitures are accounted for as they occur. The fair value of new stock options is estimated on the date of grant using a lattice-pricing model. The fair value of performance awards containing a market condition is valued using a Monte Carlo valuation model. Determining the fair value at the grant date requires judgment, including estimates for the average risk-free interest rate, dividend yield, volatility, and exercise behavior. These assumptions may differ significantly between grant dates because of changes in the actual results of these inputs that occur over time.
Compensation expense recorded in 2018, 2017, and 2016 was $50 ($39 after-tax), $54 ($36 after-tax), and $76 ($51 after-tax), respectively.
Income Taxes. The provision for income taxes is determined using the asset and liability approach of accounting for income taxes. Under this approach, the provision for income taxes represents income taxes paid or payable (or received or receivable) for the current year plus the change in deferred taxes during the year. Deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and liabilities are recovered or paid, and result from differences between the financial and tax bases of Arconic’s assets and liabilities and are adjusted for changes in tax rates and tax laws when enacted.
The 2017 Act created a new requirement that certain income earned by foreign subsidiaries, Global Intangible Low Taxed Income (GILTI), must be included in the gross income of the U.S. shareholder. The 2017 Act also established the Base Erosion and Anti-Abuse Tax (BEAT). Until regulations are finalized, judgement will be required to apply preliminary guidance, including proposed regulations, to Arconic’s facts and circumstances.
Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not that a tax benefit will not be realized. In evaluating the need for a valuation allowance, management considers all potential sources of taxable income, including income available in carryback periods, future reversals of taxable temporary differences, projections of taxable income, and income from tax planning strategies, as well as all available positive and negative evidence. Positive evidence includes factors such as a history of profitable operations, projections of future profitability within the carryforward period, including from tax planning strategies, and Arconic’s experience with similar operations. Existing favorable contracts and the ability to sell products into established markets are additional positive evidence. Negative evidence includes items such as cumulative losses, projections of future losses, or carryforward periods that are not long enough to allow for the utilization of a deferred tax asset based on existing projections of income. Deferred tax assets for which no valuation allowance is recorded may not be realized upon changes in facts and circumstances, resulting in a future charge to establish a valuation allowance. Existing valuation allowances are re-examined under the same standards of positive and negative evidence. If it is determined that it is more likely than not that a deferred tax asset will be realized, the appropriate amount of the valuation allowance, if any, is released. Deferred tax assets and liabilities are also re-measured to reflect changes in underlying tax rates due to law changes and the granting and lapse of tax holidays.
In 2018, Arconic made a final accounting policy election to apply a tax law ordering approach when considering the need for a valuation allowance on net operating losses expected to offset GILTI income inclusions. Under this approach, reductions in cash tax savings are not considered as part of the valuation allowance assessment. Instead, future GILTI inclusions are considered a source of taxable income that supports the realizability of deferred tax assets.
Tax benefits related to uncertain tax positions taken or expected to be taken on a tax return are recorded when such benefits meet a more likely than not threshold. Otherwise, these tax benefits are recorded when a tax position has been effectively settled, which means that the statute of limitations has expired or the appropriate taxing authority has completed their examination even though the statute of limitations remains open. Interest and penalties related to uncertain tax positions are recognized as part of the provision for income taxes and are accrued beginning in the period that such interest and penalties would be applicable under relevant tax law until such time that the related tax benefits are recognized.
Recently Adopted Accounting Guidance. See the Recently Adopted Accounting Guidance section of Note A to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K.
Recently Issued Accounting Guidance. See the Recently Issued Accounting Guidance section of Note A to the Consolidated Financial Statements in Part II, Item 8. (Financial Statements and Supplementary Data) of this Form 10-K.
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