Item 5. Operating and Financial Review and Prospects

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Item 5. Operating and Financial Review and Prospects

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Critical Accounting Estimates

The preparation of financial statements and related disclosures in accordance with U.S. GAAP requires our management to make judgments, assumptions and estimates that affect the amounts reported in our Consolidated Financial Statements and the accompanying notes. Our management bases its estimates and judgments on historical experience, current economic and industry conditions and on various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

The methods, estimates, and judgments that we use in applying our accounting policies have a significant impact on the results that we report in our Consolidated Financial Statements. Some of our accounting policies require us to make difficult and subjective judgments, often as a result of the need to make estimates regarding matters that are inherently uncertain. Our most critical accounting estimates include:

•the valuation of inventory, which impacts gross margin;
•the assessment of recoverability of goodwill, identified intangible assets and tangible fixed assets, which impacts gross margin or operating expenses when we record asset impairments or accelerate their depreciation or amortization;
•revenue recognition, which impacts our results of operations;
•the recognition of current and deferred income taxes (including the measurement of uncertain tax positions), which impacts our provision for income taxes;
•the assumptions used in the determination of postretirement benefit obligations, which impacts operating expenses;
•the assumptions used in the determination of share based compensation, which impacts gross margin and operating expenses; and
•the recognition and measurement of loss contingencies, which impacts gross margin or operating expenses when we recognize a loss contingency or revise the estimates for a loss contingency.

In the following section, we discuss these policies further, as well as the estimates and judgments involved.

Inventories

Inventories are valued at the lower of cost or market. We regularly review our inventories and write down our inventories for estimated losses due to obsolescence. This allowance is determined for groups of products based on sales of our products in the recent past and/or expected future demand. Future demand is affected by market conditions, technological obsolescence, new products and strategic plans, each of which is subject to change with little or no forewarning. In estimating obsolescence, we utilize information that includes projecting future demand.

The need for strategic inventory levels to ensure competitive delivery performance to our customers are balanced against the risk of inventory obsolescence due to rapidly changing technology and customer requirements.

The change in our reserves for inventories was primarily due to the normal review and accrual of obsolete or excess inventory. If actual future demand or market conditions are less favorable than those projected by our management, additional inventory write-downs may be required.

Goodwill

Goodwill is required to be tested for impairment at least annually or sooner whenever events or changes in circumstances indicate that the assets may be impaired. Such events or changes in circumstances can be significant changes in business climate, operating performance or competition, or upon the disposition of a significant portion of a reporting unit. A significant amount of judgment is involved in determining if an indicator of impairment has occurred between annual test dates. This impairment review compares the fair value for each reporting unit containing goodwill to its carrying value. Determining the fair value of a reporting unit involves the use of significant estimates and assumptions, including projected future cash flows, discount rates based on weighted average cost of capital and future economic and market conditions. We base our fair-value estimates on assumptions we believe to be reasonable. Actual cash flow amounts for future periods may differ from estimates used in impairment testing.

For the annual impairment assessment in 2018, we determined that for each of our reporting units, it was more likely than not that the fair value of the reporting units exceeded the carrying value. During the fourth quarter of each of the prior two fiscal years, we have completed our annual impairment assessments and concluded that goodwill was not impaired in any of these years.

Impairment or disposal of identified intangible assets and tangible fixed assets

We perform reviews of property, plant and equipment, and certain identifiable intangibles, excluding goodwill, to determine if facts and circumstances indicate that the useful life is shorter than what we had originally estimated or that the carrying amount of assets may not be recoverable. If such facts and circumstances exist, we assess the recoverability of the long-lived assets by comparing the projected undiscounted net cash flows associated with the related asset or group of assets over their remaining lives against their respective carrying amounts. In the event such cash flows are not expected to be sufficient to recover the recorded value of the assets, the assets are written down to their estimated fair values based on the expected discounted future cash flows attributable to the assets or based on appraisals. Impairment losses, if any, are based on the excess of the carrying amount over the fair value of those assets.

The assumptions and estimates used to determine future values and remaining useful lives of our intangible and other long-lived assets are complex and subjective. They can be affected by various factors, including external factors such as industry and economic trends, and internal factors such as changes in our business strategy and our forecasts for specific product lines. In 2018, we had no impairments. In 2017, we recognized impairment charges of $23 million, of which $16 million (2016: $89 million) relative to IPR&D that was acquired from Freescale.

Revenue recognition

The Company recognizes revenue under the core principle to depict the transfer of control to customers in an amount reflecting the consideration the Company expects to be entitled. In order to achieve that core principle, the Company applies the following five step approach: (1) identify the contract with a customer, (2) identify the performance obligations in the contract, (3) determine the transaction price, (4) allocate the transaction price to the performance obligations in the contract, and (5) recognize revenue when a performance obligation is satisfied.

The vast majority of the Company’s revenue is derived from the sale of semiconductor products to distributors, Original Equipment Manufacturers (“OEMs”) and similar customers. In determining the transaction price, the Company evaluates whether the price is subject to refund or adjustment to determine the consideration to which the Company expects to be entitled. Variable consideration is estimated and includes the impact of discounts, price protection, product returns and distributor incentive programs. The estimate of variable consideration is dependent on a variety of factors, including contractual terms, analysis of historical data, current economic conditions, industry demand and both the current and forecasted pricing environments. The estimate of variable consideration is not constrained because the Company has extensive experience with these contracts.

Revenue is recognized when control of the product is transferred to the customer (i.e., when the Company’s performance obligation is satisfied), which typically occurs at shipment. In determining whether control has transferred, the Company considers if there is a present right to payment and legal title, and whether risks and rewards of ownership having transferred to the customer.

For sales to distributors, revenue is recognized upon transfer of control to the distributor. For some distributors, contractual arrangements are in place which allow these distributors to return products if certain conditions are met. These conditions generally relate to the time period during which a return is allowed and reflect customary conditions in the particular geographic market. Other return conditions relate to circumstances arising at the end of a product life cycle, when certain distributors are permitted to return products purchased during a pre-defined period after the Company has announced a product’s pending discontinuance. These return rights are a form of variable consideration and are estimated using the most likely method based on historical return rates in order to reduce revenues recognized. However, long notice periods associated with these announcements prevent significant amounts of product from being returned. For sales where return rights exist, the Company has determined, based on historical data, that only a very small percentage of the sales of this type to distributors is actually returned. Repurchase agreements with OEMs or distributors are not entered into by the Company.

Sales to most distributors are made under programs common in the semiconductor industry whereby distributors receive certain price adjustments to meet individual competitive opportunities. These programs may include credits granted to distributors, or allow distributors to return or scrap a limited amount of product in accordance with contractual terms agreed upon with the distributor, or receive price protection credits when our standard published prices are lowered from the price the distributor paid for product still in its inventory. In determining the transaction price, the Company considers the price adjustments from these programs to be variable consideration that reduce the amount of revenue recognized. The Company’s policy is to estimate such price adjustments using the most likely method based on rolling historical experience rates, as well as a prospective view of products and pricing in the distribution channel for distributors who participate in our volume rebate incentive program. We continually monitor the actual claimed allowances against our estimates, and we adjust our estimates as appropriate to reflect trends in pricing environments and inventory levels. The estimates are also adjusted when recent historical data does not represent anticipated future activity. Historically, actual price adjustments for these programs relative to those estimated have not materially differed.

Income taxes

Deferred tax assets and liabilities are recognized for the expected tax consequences of temporary differences between the tax basis of assets and liabilities and their reported amounts. Measurement of deferred tax assets and liabilities is based upon the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Deferred tax liabilities for withholding taxes on dividends from subsidiaries are recognized in situations where the company does not consider the earnings indefinitely reinvested and to the extent that these withholding taxes are not expected to be refundable.

Deferred tax assets, including assets arising from loss carryforwards, are recognized, net of a valuation allowance, if based upon the available evidence it is more likely than not that the asset will be realized.

The income tax benefit from an uncertain tax position is recognized only if it is more likely than not that the tax position will be sustained upon examination by the relevant taxing authorities. The income tax benefit recognized is measured based on the largest benefit that is more than 50% likely to be realized upon resolution of the uncertainty. Unrecognized tax benefits are presented as a reduction to the deferred tax asset for related net operating loss carryforwards, unless these would not be available, in which case the uncertain tax benefits are presented together with the related interest and penalties as a liability, under accrued liabilities and other non-current liabilities based on the timing of the expected payment. Penalties are recorded as income tax expense, whereas interest is reported as financial expense in the statement of operations.

Postretirement benefits

The Company’s employees participate in pension and other postretirement benefit plans in many countries. The costs of pension and other postretirement benefits and related assets and liabilities with respect to the Company’s employees participating in defined-benefit plans are based upon actuarial valuations.

The projected defined-benefit obligation is calculated annually by qualified actuaries using the projected unit credit method. For the Company’s major plans, the discount rate is derived from market yields on high quality corporate bonds. Plans in countries without a deep corporate bond market use a discount rate based on the local government bond rates.

In calculating obligation and expense, the Company is required to select actuarial assumptions. These assumptions include discount rate, expected long-term rate of return on plan assets and rates of increase in compensation costs determined based on current market conditions, historical information and consultation with and input from our actuaries. Changes in the key assumptions can have a significant impact to the projected benefit obligations, funding requirements and periodic pension cost incurred. A sensitivity analysis is provided in note 14, “Postretirement Benefit Plans”.

The Company determines the fair value of plan assets based on quoted prices or comparable prices for non-quoted assets. For a defined-benefit pension plan, the benefit obligation is the projected benefit obligation; for any other postretirement defined benefit plan it is the accumulated postretirement benefit obligation.

Share-based compensation

We recognize compensation expense for all share-based awards based on the grant-date estimated fair values, net of an estimated forfeiture rate. We use the Black-Scholes option pricing model to determine the estimated fair value for certain awards. Share-based compensation cost for restricted share units (“RSU”s) with time-based vesting is measured based on the closing fair market value of our common stock on the date of the grant, reduced by the present value of the estimated expected future dividends, and then multiplied by the number of RSUs granted. Share-based compensation cost for performance-based share units (“PSU”s) granted with performance or market conditions is measured using a Monte Carlo simulation model on the date of grant.

Our valuation models and generally accepted valuation techniques require us to make assumptions and to apply judgment to determine the fair value of our awards. These assumptions and judgments include estimating the volatility of our stock price, expected dividend yield, employee turnover rates and employee stock option exercise behaviors. When establishing the expected life assumption, we used the ‘simplified’ method prescribed in ASC Topic 718 for companies that do not have adequate historical data. The risk-free interest rate is measured as the prevailing yield for a U.S. Treasury security with a maturity similar to the expected life assumption. We also estimate a forfeiture rate at the time of grant and revise this rate in subsequent periods if actual forfeitures or vesting differ from the original estimates.

We evaluate the assumptions used to value our awards on a quarterly basis. If factors change and we employ different assumptions, share-based compensation expense may differ significantly from what we have recorded in the past. If there are any modifications or cancellation of the underlying unvested securities, we may be required to accelerate, increase or cancel any remaining unearned share-based compensation expense.

Litigation and claims

We are regularly involved as plaintiffs or defendants in claims and litigation related to our past and current business operations. The claims can cover a broad range of topics, including intellectual property, reflecting the Company’s identity as a global manufacturing and technology business. The Company vigorously defends itself against improper claims, including those asserted in litigation. Due to the unpredictable nature of litigation, there can be no assurance that the Company’s accruals will be sufficient to cover the extent of its potential exposure to losses but, historically, legal actions have not had a material adverse effect on the Company’s business, results of operations or financial condition.

The estimated aggregate range of reasonably possible losses is based on currently available information in relation to the claims that have arisen and on the Company’s best estimate of such losses for those cases for which such estimate can be made. For certain claims, the Company believes that an estimate cannot currently be made. The estimated aggregate range requires significant judgment, given the varying stages of the proceedings (including the fact that many of them are currently in preliminary stages), the existence of multiple defendants (including the Company) in such claims whose share of liability has yet to be determined, the numerous yet-unresolved issues in many of the claims, and the attendant uncertainty of the various potential outcomes of such claims. Accordingly, the Company’s estimate will change from time to time, and actual losses may be more than the current estimate.

Use of Certain Non-GAAP Financial Measures

Net debt is a non-GAAP financial measure and represents total debt (short-term and long-term) after deduction of cash and cash equivalents. Management believes this measure is an appropriate reflection of our net leverage.

We understand that, although net debt is used by investors and securities analysts in their evaluation of companies, this concept has limitations as an analytical tool and it should not be used as an alternative to any other measure in accordance with U.S. GAAP.

A. Operating Results

Year Ended December 31, 2018 Compared to Year Ended December 31, 2017

Results of Operations

The following table presents the composition of operating income for the years ended December 31, 2018 and 2017.

($ in millions, unless otherwise stated)20182017
Revenue9,4079,256
% nominal growth1.6(2.5)
Gross profit4,8514,619
Research and development(1,700)(1,554)
Selling, general and administrative (SG&A)(993)(1,090)
Amortization of acquisition-related intangible assets(1,449)(1,448)
Other income (expense)2,0011,575
Operating income (loss)2,7102,102

Revenue

The following table presents revenue by segment for the years ended December 31, 2018 and 2017.

20182017
($ in millions, unless otherwise stated)Revenue% nominal growthRevenue% nominal growth
High Performance Mixed Signal (“HPMS”)9,0223.28,7458.1
Standard Products (“SP”)--118(90.3)
Corporate and Other385(2.0)393104.7
Total9,4071.69,256(2.5)

Revenue increased by $151 million to $9,407 million in 2018 compared to $9,256 million in 2017, a nominal increase of 1.6%, despite the industry wide slowdown in the fourth quarter of 2018 and the inclusion of one month of revenue of the divested SP business in 2017.

Our HPMS segment reported an increase in revenue of $277 million to $9,022 million in 2018 compared to $8,745 million in 2017, resulting in 3.2% nominal growth. The increase was primarily due to increased demand in Automotive and Secure Connected Devices and to a lesser extent in Secure Identification Solutions, partly offset by lower sales in Secure Interface & Infrastructure due to lower overall market demand.

Revenue for Corporate and Other amounted to $385 million in 2018, compared to $393 million in 2017 and mainly related to our manufacturing operations, including revenue derived from services to Nexperia.

Gross Profit

The following table presents gross profit by segment for the years ended December 31, 2018 and 2017.

20182017
($ in millions, unless otherwise stated)Gross Profit% of segment revenueGross Profit% of segment revenue
HPMS4,82253.44,52751.8
SP--4538.1
Corporate and Other297.54712.0
Total4,85151.64,61949.9

Gross profit in 2018 was $4,851 million, or 51.6% of revenue, compared to $4,619 million, or 49.9% of revenue in 2017. The increase of $232 million was primarily driven by incremental revenue generated in 2018 as well as lower depreciation related to the purchase accounting from the Freescale acquisition and partly offset by the divestment of SP.

Our HPMS segment had a gross profit of $4,822 million, or 53.4% of revenue in 2018, compared to $4,527 million, or 51.8% of revenue in 2017. The increase of $295 million was primarily driven by incremental revenue generated in 2018 as well as lower depreciation related to the purchase accounting from the Freescale acquisition.

Operating Expenses

The following table presents operating expenses by segment for the years ended December 31, 2018 and 2017.

20182017
($ in millions, unless otherwise stated)Operating expenses% of segment revenueOperating expenses% of segment revenue
HPMS4,01444.53,87144.3
SP--1411.9
Corporate and Other12833.220752.7
Total4,14244.04,09244.2

The following table below presents the composition of operating expenses by line item in the statement of operations.

($ in millions, unless otherwise stated)20182017
Research and development1,7001,554
Selling, general and administrative9931,090
Amortization of acquisition-related intangible assets1,4491,448
Operating expenses4,1424,092

Operating expenses were $4,142 million, or 44.0% of revenue in 2018, compared to $4,092 million, or 44.2% of revenue in 2017, an increase of $50 million. This was the result of higher expenses in R&D, partly offset by lower cost in SG&A due to a continued focus on cost control, lower merger related expenses and the divestment of SP.

In our HPMS segment, operating expenses amounted to $4,014 million, or 44.5% of revenue in 2018, compared to $3,871 million, or 44.3% of revenue in 2017. The increase was primarily the result of higher expenses in R&D.

Operating expenses in Corporate and Other amounted to $128 million, or 33.2% of revenue in 2018, compared to $207 million or 52.7% of revenue in 2017. The decrease in operating expenses was a result of less incurred expenses associated with the terminated proposed acquisition by Qualcomm Incorporated (6 months of merger cost in 2018 compared to a full year of merger cost in 2017).

Restructuring Charges

Total restructuring and restructuring related costs amounted to $6 million in 2018, compared to $1 million in 2017.

Other Income (Expense)

The following table presents other income (expense) for the years ended December 31, 2018 and 2017.

($ in millions, unless otherwise stated)20182017
Other income (expense)2,0011,575

Other income (expense) reflects income of $2,001 million for 2018, compared to $1,575 million of income in 2017. Included in 2018 is the break-up fee received from Qualcomm, whereas the 2017 amount included the realized gain of $1,597 million on the sale of the SP business to JAC Capital.

Financial Income (Expense)

($ in millions)For the years ended December 31,
20182017
Interest income4827
Interest expense(273)(310)
Foreign exchange rate results(14)(30)
Net gain (loss) on extinguishment of debt(26)(41)
Other(70)(12)
Total(335)(366)

Financial income (expense) was an expense of $335 million in 2018, compared to an expense of $366 million in 2017. The change in financial income (expense) is primarily attributable to (i) the decrease in interest expense, net, as a result of repayment of debt in 2018, (ii) a favorable impact of foreign exchange rate results and (iii) lower debt extinguishment cost related to repayment of debt, offset by (a) a one-time charge ($60 million) on certain financial instruments for compensation related to an adjustment event required by the termination of the Qualcomm Purchase Agreement and (b) fees for the Bridge loan.

Benefit (Provision) for Income Taxes

We recorded an income tax expense of $176 million in 2018, which reflects an effective tax rate of 7.4% compared to a benefit of $483 million (27.8%) in 2017. The effective tax rate reflects the impact of tax incentives, a portion of our earnings being taxed in foreign jurisdictions at rates different than the Netherlands statutory tax rate, adjustments of prior years’ income taxes and the mix of income and losses in various jurisdictions. The impact of these items results in offsetting factors that attribute to the change in the effective tax rate between the two periods, with the significant drivers outlined below:

•The U.S. Tax Cuts and Jobs Act is the primary driver for the change between the two periods as a result of the one-time benefit of $734 million we received in 2017, which only had an impact of an additional income tax benefit of $3 million in 2018.
•The Netherlands tax incentives increased in 2018 due to the fact that NXP reached an agreement with the Dutch tax authorities relative to the application of the Dutch innovation box regime to the taxable income attributable to the Netherlands. In addition to this, in 2018, NXP received a break-up fee from Qualcomm of $2,000 million which helped drive a higher income before tax in 2018 than in 2017, even though in 2017 NXP had realized a gain of $1,597 million on the divestment of SP business.
•The adjustments to prior years’ income taxes increased in 2018 as a result of the aforementioned agreement which is effective from January 1, 2017. As such, the Company was able to refine its estimate of the Dutch tax liability, recognizing an additional income tax benefit of $67 million in 2018.
•The other differences in 2018 relate primarily to a tax benefit on the liquidation of a former investment of $45 million.

On a go-forward basis, cash payments for corporate income taxes that are relative to our on-going operations are expected to remain at $30-35 million per quarter during 2019. Our future cash payments for income taxes will also be impacted by the following non-recurring events, resulting in additional payments of $349 million in total, with $298 million being paid in 2019 and $51 million being paid in 2020.

Results Relating to Equity-accounted Investees

Results relating to equity-accounted investees amounted to a gain of $59 million in 2018, which includes a net gain realized of $51 million resulting from the sale of ASEN in July 2018. In 2017, results relating to equity-accounted investees amounted to a gain of $53 million, including a gain of $31 million resulting from the sale of ASMC in April 2017.

Non-controlling Interests

Non-controlling interests are related to the third-party share in the results of consolidated companies, predominantly SSMC. Their share of non-controlling interests amounted to a profit of $50 million in 2018, compared to a profit of $57 million in 2017.

Year Ended December 31, 2017 Compared to Year Ended December 31, 2016

Results of Operations

The following table presents the composition of operating income for the years ended December 31, 2017 and 2016.

($ in millions, unless otherwise stated)20172016
Revenue9,2569,498
% nominal growth(2.5)55.7
Gross profit4,6194,069
Research and development(1,554)(1,560)
Selling, general and administrative (SG&A)(1,090)(1,141)
Amortization of acquisition-related intangible assets(1,448)(1,527)
Other income (expense)1,5759
Operating income (loss)2,102(150)

Revenue

The following table presents revenue by segment for the years ended December 31, 2017 and 2016.

20172016
($ in millions, unless otherwise stated)Revenue% nominal growthRevenue% nominal growth
High Performance Mixed Signal (“HPMS”)8,7458.18,08671.3
Standard Products (“SP”)118(90.3)1,220(1.7)
Corporate and Other393104.719237.1
Total9,256(2.5)9,49855.7

Revenue decreased by $242 million to $9,256 million in 2017 compared to $9,498 million in 2016, a nominal decrease of 2.5%, reflecting the divestment of the SP business.

Our HPMS segment reported an increase in revenue of $659 million to $8,745 million in 2017 compared to $8,086 million in 2016, resulting in 8.1% nominal growth. The increase was primarily due to increased demand in Automotive and Secure Connected Devices and to a lesser extent in Secure Interface & Infrastructure offset by lower sales in Secure Identification Solutions due to a combination of lower overall market demand and average sales price compression.

Revenue for our SP segment was $118 million in 2017, compared to $1,220 million in 2016. The decrease was attributable to the divestment of the SP business on February 6, 2017. As of the divestment date, revenue derived from services to the former SP activities (Nexperia) in order to support their separation and, on a limited basis, their ongoing operations, is included in the Corporate & Other segment. As the Nexperia business develops or acquires its own foundry and packaging capabilities, our revenue from this source is expected to decline.

Revenue for Corporate and Other amounted to $393 million in 2017, compared to $192 million in 2016 and mainly related to our manufacturing operations, including revenue derived from services to Nexperia.

Gross Profit

The following table presents gross profit by segment for the years ended December 31, 2017 and 2016.

20172016
($ in millions, unless otherwise stated)Gross Profit% of segment revenueGross Profit% of segment revenue
HPMS4,52751.83,62544.8
SP4538.143735.8
Corporate and Other4712.073.6
Total4,61949.94,06942.8

Gross profit in 2017 was $4,619 million, or 49.9% of revenue compared to $4,069 million, or 42.8% of revenue in 2016. The increase of $550 million was primarily driven by the absence of the impact of purchase accounting on inventory recognized in 2016, as a result of the acquisition of Freescale, in addition to the continued improvement of our operational performance and improved product mix, partly offset by the impact of the divestment of SP.

Our HPMS segment had a gross profit of $4,527 million, or 51.8% of revenue in 2017, compared to $3,625 million, or 44.8% of revenue in 2016. The increase in the gross profit percentage of 7.0 points as a percentage of revenue was primarily driven by the absence of the impact of purchase accounting on inventory ($448 million) in 2016, in addition to the continued improvement of our operational performance and improved product mix.

Gross profit in our SP segment was $45 million, or 38.1% of revenue in 2017, compared to $437 million, or 35.8% of revenue in 2016. The decrease in gross profit was a result of the divestment of the SP business on February 6, 2017.

Operating Expenses

The following table presents operating expenses by segment for the years ended December 31, 2017 and 2016.

20172016
($ in millions, unless otherwise stated)Operating expenses% of segment revenueOperating expenses% of segment revenue
HPMS3,87144.33,93748.7
SP1411.916813.8
Corporate and Other20752.712364.1
Total4,09244.24,22844.5

The following table below presents the composition of operating expenses by line item in the statement of operations.

($ in millions, unless otherwise stated)20172016
Research and development1,5541,560
Selling, general and administrative1,0901,141
Amortization of acquisition-related intangible assets1,4481,527
Operating expenses4,0924,228

Operating expenses were $4,092 million, or 44.2% of revenue in 2017, compared to $4,228 million, or 44.5% of revenue in 2016, a decrease of $136 million. The decrease in operating expenses was primarily the result of realized synergies from the acquisition of Freescale, lower expenses related to the amortization of acquisition-related intangible assets, in addition to the impact of the divestment of SP, with only one month of operating activities in the current period.

In our HPMS segment, operating expenses amounted to $3,871 million, or 44.3% of revenue in 2017, compared to $3,937 million, or 48.7% of revenue in 2016. The decrease was primarily the result of realized synergies from the acquisition of Freescale and lower expenses related to the amortization of acquisition-related intangible assets.

Operating expenses in our SP segment decreased to $14 million, or 11.9% of revenue in 2017, compared to $168 million or 13.8% of revenue in 2016. The decrease in operating expenses was a result of the divestment of the SP business on February 6, 2017.

Operating expenses in Corporate and Other amounted to $207 million, or 52.7% of revenue in 2017, compared to $123 million or 64.1% of revenue in 2016. The increase in operating expenses was a result of incurred expenses associated with the proposed acquisition by QUALCOMM Incorporated and increased legal costs in connection with potential and current legal proceedings. The decrease in operating expenses as a percentage of revenue is driven by the increase in revenue as a result of the services we now provide to Nexperia.

Restructuring Charges

Total restructuring and restructuring related costs amounted to $1 million in 2017, compared to $68 million in 2016.

In 2016, the restructuring charges were for various specific targeted actions and were comprised of employee severance costs.

Other Income (Expense)

The following table presents other income (expense) for the years ended December 31, 2017 and 2016.

($ in millions, unless otherwise stated)20172016
Other income (expense)1,5759

Other income (expense) reflects income of $1,575 million for 2017 compared to $9 million of income in 2016. Included in 2017 is the realized gain of $1,597 million on the sale of the SP business in 2017.

Financial Income (Expense)

($ in millions)For the years ended December 31,
20172016
Interest income2711
Interest expense(310)(408)
Foreign exchange rate results(30)(15)
Net gain (loss) on extinguishment of debt(41)(32)
Other(12)(9)
Total(366)(453)

Financial income (expense) was an expense of $366 million in 2017, compared to an expense of $453 million in 2016. The change in financial income (expense) is primarily attributable to (i) the decrease in interest expense, net, as a result of repayment of debt in 2017, offset by (ii) a less favorable impact of foreign exchange rate results and by (iii) higher debt extinguishment cost related to repayment of debt.

Benefit (Provision) for Income Taxes

The effective tax rate reflects the impact of tax incentives, a portion of our earnings being taxed in foreign jurisdictions at rates different than the Netherlands statutory tax rate and the mix of income and losses in various jurisdictions. We recorded a tax benefit of $483 million in 2017, which reflects a benefit of 27.8% compared with a benefit of $851 million (141.1%) for 2016.

On December 22, 2017, the President of the United States signed into law what is informally called the Tax Cuts and Jobs Act, a comprehensive U.S. tax reform package that, effective January 1, 2018, among other things, lowered the corporate income tax rate from 35% to 21%, moved the country towards a territorial tax system with a one-time mandatory tax on previously deferred foreign earnings of foreign subsidiaries and introduced a 30% limitation on deductibility of interest. Under the accounting rules, companies are required to recognize the effects of changes in tax laws and tax rates on deferred tax assets and liabilities in the period in which the new legislation is enacted. The effects of the Tax Cuts and Jobs Act on NXP include three major categories (i) re-measurement of deferred taxes, (ii) reassessment of the realizability of deferred tax assets and (iii) recognition of liabilities for taxes on mandatory deemed repatriation. As described further below, we recorded an income tax benefit of $734 million in the year ended December 31, 2017. As we do not have all the necessary information to analyze all income tax effects of the Tax Cuts and Jobs Act, this is a provisional amount which we believe represents a reasonable estimate of the accounting implications of this tax reform. We will continue to evaluate the Tax Cuts and Jobs Act and adjust the provisional amounts as additional information is obtained. The ultimate impact of tax reform may differ from our provisional amounts due to changes in our interpretations and assumptions, as well as additional regulatory guidance that may be issued.

We expect to complete our detailed analysis no later than the fourth quarter of 2018. Below is a brief description of each of the three categories of effects from U.S. tax reform and its impact on the Company:

i.A deferred tax benefit of $565 million related to the revaluation of NXP USA’s net deferred tax liabilities due to the reduction of the U.S. corporate tax rate from 35% to 21%. The Company believes that the disallowed interest available per end of full year 2017 can still be carried forward and therefore continued to recognize a deferred tax asset of $156 million in this respect.
ii.A deferred tax benefit of $277 million for the reversal of net deferred tax liabilities previously accrued related to NXP USA’s cumulative undistributed foreign earnings. The Company believes this is a reasonable estimate of the impact of the Tax Cuts and Jobs Act but considers the release of this deferred tax liability as provisional pending further interpretation and guidance regarding whether future distribution from pre-1987 earnings and profits (E&P) will be subject to U.S. income tax.
iii.A deferred tax expense of $108 million for the mandatory repatriation “Toll Tax”. The Company expects to utilize part of its unused foreign tax credit carryforwards that existed at the end of 2016 to fully cover the Toll Tax. Additional work is necessary to do a more detailed analysis of post-1986 earnings and profits (E&P) and creditable foreign-taxes of U.S.-owned subsidiaries. Further, the Toll Tax is based in part on the amount of those earnings held in cash and other specific assets, which may be further defined by regulatory guidance.

As previously discussed, on February 6, 2017 we divested Standard Products, receiving $2.75 billion in cash proceeds. In relation to the gain that will be realized, the Company currently estimates that we will incur approximately $360 million of capital gains taxes

that will come due in increments during 2017-2019. Cash payments for income taxes that are relative to our ongoing operations are expected to remain at $35 to $40 million per quarter during 2018. In relation to the gain we made additional cash payments in 2017 of $270 million. For the period 2018-2019, we currently estimate additional cash payments relative to this gain of $90 million.

In the fourth quarter of 2017, the Company recorded an adjustment to recognize tax expense in the amount of $121 million related to the first three quarters of 2017. The adjustment relates to transfer pricing and purchase accounting. Other than the amount related to goodwill (see note 13), the adjustment did not impact financial statements for the years ended December 31, 2016 or 2015.

Results Relating to Equity-accounted Investees

Results relating to the equity-accounted investees amounted to a gain of $53 million in 2017, which includes $31 million gain resulting from the sale of ASMC in April 2017. In 2016, results relating to the equity-accounted investees amounted to a gain of $11 million.

Non-controlling Interests

Non-controlling interests are related to the third party share in the results of consolidated companies, predominantly SSMC. Their share of non-controlling interests amounted to a profit of $57 million in 2017, compared to a profit of $59 million in 2016.

B. Liquidity and Capital Resources

Liquidity and Capital Resources

We derive our liquidity and capital resources primarily from our cash flows from operations. We continue to generate strong positive operating cash flows. As of December 31, 2018, our cash balance was $2,789 million, a decrease of $758 million compared to December 31, 2017 ($3,547 million). Taking into account the available undrawn amount of the Secured Revolving Credit Facility (the “RCF Agreement”) of $600 million, we had access to $3,389 million of liquidity as of December 31, 2018.

We currently use cash to fund operations, meet working capital requirements, for capital expenditures and for potential common stock repurchases, dividends and strategic investments. Based on past performance and current expectations, we believe that our current available sources of funds (including cash and cash equivalents, RCF Agreement, plus anticipated cash generated from operations) will be adequate to finance our operations, working capital requirements, capital expenditures and potential dividends for at least the next year. Our capital expenditures were $611 million in 2018, compared to $552 million in 2017. On July 26, 2018, subsequent to the termination of the purchase agreement, the board of directors of NXP authorized the repurchase of an additional $5 billion of the Company’s stock. During October 2018, the board of directors of NXP authorized the additional repurchase of approximately 15 million shares. The extended authorization, effective November 1, 2018, is above the completed $5 billion share repurchase program announced on July 26, 2018. As of year-end 2018, NXP repurchased 54.4 million shares, for a total of approximately $5 billion. Under Dutch tax law, the repurchase of a company’s shares by an entity domiciled in the Netherlands results in a taxable event. The tax on the repurchased shares is attributed to the shareholders, with NXP making the payment on the shareholders’ behalf. As such, the tax on the repurchased shares is accounted for within stockholders’ equity.

On November 16, 2018, the Company, as authorized by the June 2018 AGM, cancelled 5% (representing 17,300,143 shares) of the issued number of NXP shares. As a result, the number of issued NXP shares as per November 16, 2018 is 328,702,719 shares.

On September 10, 2018, NXP announced the initiation of a Quarterly Dividend Program under which the Company intends to pay a regular quarterly cash dividend. Accordingly, interim dividends of $0.25 per ordinary share were paid on October 5, 2018 and January 7, 2019.

Our total debt amounted to $7,354 million as of December 31, 2018, an increase of $789 million compared to December 31, 2017 ($6,565 million). On April 2, 2018, we fully redeemed the $500 million of outstanding principal amount of our 5.75% Senior Notes due 2023 using available surplus cash. Additionally, on April 9, 2018, we fully redeemed the $750 million of outstanding principal amount of our 3.75% Senior Notes due 2018 using available surplus cash. On September 19, 2018, we entered into a $1 billion senior unsecured bridge term credit facility agreement under which an aggregate principal amount of $1 billion (the “Bridge Loan”) was borrowed. On December 6, 2018, NXP entered into 3 new senior unsecured notes, which are due in 2024 ($1 billion), 2026 ($500 million) and 2028 ($500 million). A portion of the net proceeds from the December 6, 2018 notes offering was used to repay the $1 billion Bridge Loan in December 2018.

At December 31, 2018, our cash balance was $2,789 million, of which $140 million was held by SSMC, our consolidated joint venture company with TSMC. Under the terms of our joint venture agreement with TSMC, a portion of this cash can be distributed by way of a dividend to us, but 38.8% of the dividend will be paid to our joint venture partner. In 2018, a dividend of $139 million has been declared by SSMC, of which $54 million was distributed to the joint venture partner.

From time to time, we engage in discussions with third parties regarding potential acquisitions of, or investments in, businesses, technologies and product lines. Any such transaction could require significant use of our cash and cash equivalents, or require us to arrange for new debt and equity financing to fund the transaction. Our ability to make scheduled payments or to refinance our debt obligations depends on our financial and operating performance, which is subject to prevailing economic and competitive conditions. In the future, we may not be able to maintain a level of cash flows from operating activities sufficient to permit us to pay principal, premium, if any, and interest on our indebtedness. Our business may not generate sufficient cash flow from operations, or we may not have enough capacity under the RCF Agreement, or from other sources in an amount sufficient to enable us to repay our indebtedness, including the RCF Agreement, the unsecured notes or to fund our other liquidity needs, including working capital and capital expenditure requirements. In any such case, we may be forced to reduce or delay capital expenditures, sell assets or operations, seek additional capital or restructure or refinance our indebtedness. See Part I, Item 3.D. Risk Factors.

Cash Flow from Operating Activities

In 2018 our operating activities provided $4,369 million in cash. This was primarily the result of net income of $2,258 million, adjustments to reconcile the net income of $2,114 million and changes in operating assets and liabilities of ($3) million. Net income includes offsetting non-cash items, such as depreciation and amortization of $1,987 million, share-based compensation of $314 million, amortization of the discount on debt and debt issuance costs of $52 million, a loss on extinguishment of debt of $26 million, results relating to equity-accounted investees of ($54) million and changes in deferred taxes of ($211) million.

In 2017 our operating activities provided $2,447 million in cash. This was primarily the result of net income of $2,272 million, adjustments to reconcile the net income of $113 million and changes in operating assets and liabilities of $62 million. Net income includes offsetting non-cash items, such as depreciation and amortization of $2,173 million, the gain on the sale of assets of ($1,615) million, share-based compensation of $281 million, amortization of the discount on debt and debt issuance costs of $52 million, a loss on extinguishment of debt of $41 million and changes in deferred taxes of ($797) million.

In 2016 our operating activities provided $2,303 million in cash. This was primarily the result of net income of $259 million, adjustments to reconcile the net income of $1,673 million and changes in operating assets and liabilities of $371 million. The net income includes non-cash items, such as depreciation and amortization of $2,205 million, share-based compensation of $338 million, amortization of the discount on debt and debt issuance costs of $50 million, a loss on extinguishment of debt of $32 million and changes in deferred taxes of ($925) million.

Cash Flow from Investing Activities

Net cash used for investing activities amounted to $522 million in 2018 and principally consisted of the cash outflows for capital expenditures of $611 million and $50 million for the purchase of identified intangible assets, partly offset by proceeds of $159 million from the sale of businesses (net of cash).

Net cash provided by investing activities amounted to $2,072 million in 2017 and principally consisted of the cash inflow from proceeds from the sale (net of cash) of the SP business, partly offset by the cash outflows for capital expenditures of $552 million and $66 million for the purchase of identified intangible assets, mainly related to the purchase of licenses.

Net cash used for investing activities amounted to $627 million in 2016 and principally consisted of cash outflows for purchases of interests in business (net of cash) of $202 million, capital expenditures of $389 million and $59 million for the purchase of identified intangible assets, mainly related to the purchase of licenses, partly offset by proceeds of $20 million from the sale of business (net of cash).

Cash Flow from Financing Activities

Net cash used for financing activities was $4,597 million in 2018, $2,886 million in 2017 and $1,392 million in 2016. The cash flows related to financing transactions in 2018, 2017 and 2016 are primarily related to the financing activities described below under the captions 2018 Financing Activities, 2017 Financing Activities and 2016 Financing Activities, respectively.

In addition to the financing activities described below, net cash used for financing activities by year included:

Year ended December 31,
201820172016
Dividends paid to non-controlling interests(54)(89)(126)
Dividends paid to common stockholders(74)--
Cash proceeds from exercise of stock options39233115
Purchase of treasury shares(5,006)(286)(1,280)
Cash paid for terminated acquisition adjustment event(60)--
Cash paid on behalf of shareholders for tax on repurchased shares(142)--
Excess tax benefits from share-based compensation plans--5

2018 Financing Activities

2024, 2026 and 2028 Senior Unsecured Notes

On December 6, 2018, NXP B.V., together with NXP Funding LLC, issued $1 billion of 4.875% Senior Unsecured Notes due March 1, 2024, $500 million of 5.35% Senior Unsecured Notes due March 1, 2026 and $500 million of 5.55% Senior Unsecured Notes due 2028. NXP used a portion of the net proceeds of the offering of these notes to repay in full the Bridge Loan, as described below. The remaining proceeds will be used for general corporate purposes, which may include the repurchase of additional shares of NXP’s common stock.

2019 Bridge Loan

On September 19, 2018, NXP B.V., together with NXP Funding LLC, entered into a $1 billion senior unsecured bridge term credit facility agreement under which an aggregate principal amount of $1 billion of term loans (the “Bridge Loan”) was borrowed. The Bridge Loan was to mature on September 18, 2019 and the interest at a LIBOR rate plus an applicable margin of 1.5 percent. NXP used the net proceeds of the Bridge Loan for general corporate purposes as well as to finance parts of the announced equity buy-back program. On December 6, 2018, the Bridge Loan was repaid in full, as described above.

2018 Senior Notes

On March 8, 2018, NXP B.V., together with NXP Funding LLC, delivered notice that it would repay to holders of its 3.75% Senior Notes due 2018 (the “2018 Notes”) $750 million of the outstanding aggregate principal amount of the 2018 Notes, which represented all of the outstanding aggregate principal amount of the 2018 Notes. The repayment occurred in April 2018 using available surplus cash.

2023 Senior Notes

On March 2, 2018, NXP B.V., together with NXP Funding LLC, delivered notice that it would repay to holders of its 5.75% Senior Notes due 2023 (the “2023 Notes”) $500 million of the outstanding aggregate principal amount of the 2023 Notes, which represented all of the outstanding aggregate principal amount of the 2023 Notes. The repayment occurred in April 2018 using available surplus cash.

2017 Financing Activities

2017 and 2020 Term Loans

In February 2017, NXP repaid (i) all its outstanding floating-rate term loan due March 2017 in an aggregate principal amount of $388 million, (ii) all its outstanding floating-rate term loan due January 2020 in an aggregate principal amount of $387 million and (iii) all its outstanding floating-rate term loan due December 2020 in an aggregate principal amount of $1,436 million, in each case, together with accrued interest and applicable fees. The repayment occurred in February 2017 with the funds for these repayments coming from the proceeds of the divestment of the SP business.

2021 Senior Unsecured Notes

In March 2017, NXP redeemed $500 million of the outstanding aggregate principal amount of its 5.75% Senior Unsecured Notes due 2021, which represented all of the outstanding aggregate principal amount of these Notes. The funds for this redemption coming from available surplus cash.

2016 Financing Activities

2020 Term Loan

On September 22, 2016, NXP entered into a new $1,440 million aggregate principal amount Senior Secured Term Loan Facility due December 7, 2020. Concurrently, NXP repaid the $1,440 million principal amount Senior Secured Term Loan Facility due December 7, 2020.

2022 Senior Unsecured Notes

On August 11, 2016, NXP B.V., together with NXP Funding LLC, issued U.S. dollar-denominated 3.875% Senior Unsecured Notes with an aggregate principal amount of $1,000 million, due September 1, 2022. The interest is payable semi-annually on March 1 and September 1 of each year, beginning on March 1, 2017. The Notes were issued at par and were recorded at their fair value of $1,000 million on the accompanying Consolidated Balance Sheet. NXP used the net proceeds from the offering of the Notes to redeem the remaining $960 million aggregate principal amount of its outstanding Senior Secured Notes due 2022 and to pay for certain costs and expenses related thereto.

2021 Additional Senior Unsecured Notes

On August 1, 2016, NXP B.V., together with NXP Funding LLC, issued an aggregate principal amount of $500 million of 4.125% Senior Unsecured Notes due 2021 (the “Additional Notes”). The Additional Notes were issued at a price of 101.875% and are of the same class as the existing 4.125% Senior Notes due 2021 originally issued on May 23, 2016. NXP used the net proceeds from the offering of the Additional Notes to redeem $200 million aggregate principal amount of its outstanding Senior Notes due 2016 and used the remainder of the proceeds for general corporate purposes.

2021 and 2023 Senior Unsecured Notes

On May 23, 2016, NXP B.V. together with NXP Funding LLC issued U.S. dollar-denominated 4.125% and 4.625% Senior Unsecured Notes with aggregate principal amounts of $850 million, due June 1, 2021 and $900 million, due June 1, 2023. The interest is payable semi-annually on June 1 and December 1 of each year, beginning on December 1, 2016. These Notes were issued at par and were recorded at their fair value of $850 million and $900 million, respectively, on the accompanying Consolidated Balance Sheet. NXP used the net proceeds from the offering of the Notes and cash on hand to repay $1,250 million aggregate principal amount of its existing Secured Term Loan B due 2020 and $500 million aggregate principal amount of its outstanding Senior Secured Notes due 2021.

2016 Senior Unsecured Notes

On February 23, April 27 and August 1, 2016, NXP B.V., together with NXP Funding LLC, issued redemption notices for an aggregate principal amount of $200 million, $100 million and $200 million, respectively, of its outstanding 3.5% Senior Unsecured Notes due 2016. The funds from this redemption came from available surplus cash.

Debt Position

Short-term Debt

As of December 31, 2018, our short-term debt amounted to $1,107 million.

As of December 31, 2017, our short-term debt amounted to $751 million.

Long-term Debt

As of December 31, 2018, we had outstanding debt of:

($ in millions)December 31, 2017Accrual/release Original Issuance/Debt Discount and Debt Issuance CostDebt Exchanges/ Repurchases/ New BorrowingsOther(11)December 31, 2018
U.S. dollar-denominated 4.125% senior unsecured notes due June 2020(1)5971598
U.S. dollar-denominated 4.125% senior unsecured notes due June 2021 (2)1,3491,349
U.S. dollar-denominated 4.625% senior unsecured notes due June 2022 (3)3971398
U.S. dollar-denominated 4.625% senior unsecured notes due June 2023 (4)8941895
U.S. dollar-denominated 3.875% senior unsecured notes due June 2023 (5)9941995
U.S. dollar-denominated 5.75% senior unsecured notes due March 2023 (6)4973(500)-
U.S. dollar-denominated 4.875% senior unsecured notes due March 2024 (7)-(6)1,000994
U.S. dollar-denominated 5.35% senior unsecured notes due March 2026 (7)-(3)500497
U.S. dollar-denominated 5.55% senior unsecured notes due December 2028 (7)-(4)500496
U.S. dollar-denominated 1.00% cash convertible senior notes due December 2019(8)1,05946(1,105)-
5,787401,500(1,105)6,222
RCF Agreement (9)--
Other long-term debt (10)27--(2)25
Total long-term debt5,814401,500(1,107)6,247
(1)On June 9, 2015, we issued $600 million aggregate principal amount of 4.125% Senior Unsecured Notes due 2020.
(2)On May 23, 2016, and August 1, 2016, we issued $850 million and $500 million, respectively, aggregate principal amount of 4.125% Senior Unsecured Notes due 2021.
(3)On June 9, 2015, we issued $400 million aggregate principal amount of 4.625% Senior Unsecured Notes due 2022.
(4)On May 23, 2016, we issued $900 million aggregate principal amount of 4.625% Senior Unsecured Notes due 2023.
(5)On August 11, 2016, we issued $1,000 million aggregate principal amount of 3.875% Senior Unsecured Notes due 2022.
(6)On March 15, 2013, we issued $500 million aggregate principal amount of 5.75% Senior Unsecured Notes due 2023. On April 2, 2018, we fully redeemed the $500 million of outstanding principal.
(7)On December 6, 2018, we issued $1,000 million aggregate principal amount of 4.875% Senior Unsecured Notes due 2024, $500 million aggregate principal amount of 5.35% Senior Unsecured Notes due 2026 and $500 million aggregate principal amount of 5.55% Senior Unsecured Notes due 2028.
(8)On November 24, 2014, we issued $1,150 million aggregate principal amount of 1.00% Cash Convertible Senior Notes due 2019.
(9)On December 7, 2015, we entered into a $600 million Revolving Credit Facility agreement due 2020.
(10)Other long-term debt consists primarily of capital lease obligations.
(11)Other mainly relates to the reclassification of the current portion of long-term debt and the purchase price accounting step-up of the Freescale Notes.

We may from time to time continue to seek to retire or purchase our outstanding debt through cash purchases and/or exchanges, in open market purchases, privately negotiated transactions or otherwise. See the discussion in Part I, Item 5.B. Liquidity and Capital Resources and Part II, Item 10.C. Material Contracts.

Certain Terms of the 2019 Cash Convertible Senior Notes

We have issued $1,150 million aggregate principal amount of 2019 Cash Convertible Senior Notes, which bear interest at 1.00% per annum and mature on December 1, 2019, unless earlier converted, repurchased or redeemed. The 2019 Cash Convertible Senior Notes pay interest on June 1 and December 1 of each year, beginning on June 1, 2015. The 2019 Cash Convertible Senior Notes are senior unsecured obligations of NXP Semiconductor N.V. and will be settled solely in cash upon conversion. We may not redeem the 2019 Cash Convertible Senior Notes prior to their maturity date other than following the occurrence of certain tax law changes as set forth in the indenture governing the 2019 Cash Convertible Senior Notes (the “Convertible Notes Indenture”). Upon the occurrence of certain events which constitute a “fundamental change” under the Convertible Notes Indenture, such as certain change of control, the holders of 2019 Cash Convertible Senior Notes may require us to repurchase for cash all or part of their 2019 Cash Convertible Senior Notes at a price equal to 100% of the principal amount thereof plus accrued and unpaid interest.

Prior to September 1, 2019, holders may convert their 2019 Cash Convertible Senior Notes only upon satisfaction of certain conditions specified in the Convertible Notes Indentures. On or after September 1, 2019 until the close of business on the second scheduled trading day immediately preceding the maturity date, holders may, at their option, convert their 2019 Cash Convertible Senior Notes solely into cash at any time.

Upon conversion, in lieu of receiving any shares of our common stock, a holder will receive, per $1,000 principal amount of 2019 Cash Convertible Senior Notes being converted, an amount in cash equal to the settlement amount, determined as described in the Convertible Notes Indenture. The conversion rate will initially be 9.7236 shares of our common stock per $1,000 principal amount (equivalent to an initial conversion price of $102.84 per share). The conversion rate for the 2019 Cash Convertible Senior Notes is subject to customary anti-dilution adjustments and will also be adjusted for any fundamental change or tax redemption, each as described in the Convertible Notes Indenture.

Concurrently with the issuance of the 2019 Cash Convertible Senior Notes, we entered into cash convertible note hedge and warrant transactions.

Cash Convertible Note Hedge Transactions and Warrant Transactions

On November 24, 2014 and November 25, 2014, in connection with our issuances of the 2019 Cash Convertible Senior Notes, we entered into cash convertible note hedge transactions with affiliates of the initial purchasers of the 2019 Cash Convertible Senior Notes (in such capacity, the “Option Counterparties”) to offset any cash payment we are required to make in excess of the principal amount of the 2019 Cash Convertible Senior Notes.

In these transactions, we paid $208 million for call options, subject to customary anti-dilution adjustments, that cover an aggregate 11.18 million shares of NXP’s common stock, with an initial strike price of $102.84 per share. The Option Counterparties or their respective affiliates may enter into, or unwind, various over-the-counter derivatives and/or purchase or sell our common stock in open market and/or privately negotiated transactions prior to maturity of the 2019 Cash Convertible Senior Notes, including during any observation period for the settlement of conversions of the 2019 Cash Convertible Senior Notes, or upon any repurchase of the 2019 Cash Convertible Senior Notes by us, which could adversely impact the price of our common stock and of the 2019 Cash Convertible Senior Notes.

Separately, we sold warrants to the Option Counterparties for $134 million giving them the right to purchase from us, subject to customary anti-dilution adjustments, 11.18 million shares of NXP’s common stock, with an initial strike price of $133.32 per share. The warrants will have a dilutive effect with respect to our common stock to the extent that the market price per share of our common stock exceeds the strike price of the warrants on or prior to the expiration date of the warrants. The warrants expire on various dates starting from March 2, 2020, and will be net share settled. Under the terms of the warrants, each Option Counterparty may adjust certain terms of its warrants upon the announcement, termination or occurrence of certain events. The warrant transactions may also be terminated if the Option Counterparty determines that no such adjustment will produce a commercially reasonable result, and that the relevant event is reasonably likely to occur. Any such adjustment may increase our delivery obligations upon expiration and settlement of the warrants or our obligations upon their cancellation, termination or unwinding, which would be settled using shares of our stock.

C. Research and Development, Patents and Licenses, etc.

Research and Development

We believe that our future success depends on our ability to both improve our existing products and to develop new products for both existing and new markets. We direct our research and development efforts largely to the development of new HPMS semiconductor solutions where we see significant opportunities for growth. We target applications that require stringent overall system and subsystem performance. As new and challenging applications proliferate, we believe that many of these applications will benefit from our solutions. We have assembled a global team of highly skilled semiconductor and embedded software design engineers with expertise in RF, analog, power management, interface, security and digital processing. As of December 31, 2018, we had 8,452 employees in research and development.

To outpace market growth we invest in research and development to extend or create leading market positions, with an emphasis on fast growing sizable market segments, such as automotive advanced driver-assistance systems (ADAS), in-vehicle networks and power management as well as Edge computing to support the successful deployment in the Internet of Things with our cross-over processing technology, but also in emerging markets, such as massive MIMO in RF Power and millimeter wave for 5G. Finally, we invest a few percent of our total research and development expenditures in research activities that develop fundamental new technologies or product categories that could contribute significantly to our company growth in the future.

We annually perform a fundamental review of our business portfolio and our related new product and technology development opportunities in order to decide on changes in the allocation of our research and development resources. For products targeting established markets, we evaluate our research and development expenditures based on clear business need and risk assessments. For break-through technologies and new market opportunities, we look at the strategic fit and synergies with the rest of our portfolio and the size of the potential addressable market. Overall, we allocate our research and development to maintain a healthy mix of emerging growth and mature businesses.

Intellectual Property

The creation and use of intellectual property is a key aspect of our strategy to differentiate ourselves in the marketplace. We seek to protect our proprietary technologies by obtaining patents, trademarks, domain names, retaining trade secrets and defending, enforcing and utilizing our intellectual property rights, where appropriate. We believe this strategy allows us to preserve the advantages of our products and technologies, and helps us to improve the return on our investment in research and development. We have a broad portfolio of over 9,000 patent families (each patent family includes all patents and patent applications originating from the same invention). To protect certain confidential technical information and software, we rely on copyright and trade secret law and enter into confidentiality agreements as applicable. In situations where we believe that a third party has infringed on our intellectual property, we enforce our rights through all available legal means to the extent that we determine the benefits of such actions to outweigh any costs and risks involved.

We own a number of trademarks that are used in the conduct of our business. Where we consider it desirable, we develop names for our new products and secure trademark protection. Our trademarks allow us to further distinguish our company and our products and are important in our relationships with customers, suppliers, partners and end-users.

While our patents, trademarks, trade secrets and other intellectual property rights constitute valuable assets, we do not view any individual right or asset as being material to our operations as a whole. We believe it is the combination of our proprietary technology, patents, know-how and other intellectual property rights and assets that creates an advantage for our business.

In addition to obtaining our own patents and other intellectual property rights, we have entered into licensing agreements and other arrangements authorizing us to use intellectual property rights, confidential technical information, software and other technology owned by third parties. We also engage, in certain instances, in licensing and selling of certain of our technology, patents and other intellectual property rights.

D. Trend Information

NXP Semiconductors enables secure connections and infrastructure for a smarter world, providing solutions that make lives easier, better and safer. Building on our expertise in processing, connectivity and security, we are driving innovation in the areas of autonomous and safe driving, end-to-end security and privacy and smart connected solutions markets. Our innovative solutions are used in a wide range of applications. The automotive industry is seeing a transformational change centered around three megatrends: autonomous driving, safe driving and clean driving. We are responding to those changes by delivering innovative solutions for secure vehicle-to-infrastructure and vehicle-to-vehicle communication, radar, secure car access, car entertainment, in-vehicle networking and battery management solutions. The increasing number of interconnected devices (e.g., cars, smartphones, wearables, TVs, smart speakers, etc.) needing real-time analysis and secure processing is exponentially increasing the amount of processing power needed both on the edge and in the end nodes. They provide fertile new markets for our broad range of microcontrollers, application processors, connectivity and security solutions. Innovation in smartphones and tablets drives demand for our secure interface and power solutions while always-on requirements in secure connected devices further drive demand for our advanced mobile audio, sensing and connectivity solutions. Many electronic payment and government ID services are enabled by our secure identification solutions and with the transition of those services to new form factors in secure connected devices, there is strong market demand for embedded security solutions such as mobile payment, cyber-security and authentication. Next generation networks which deliver increasing demand for data are enabled by our new high-performance RF solutions.

Currently we see the first quarter of 2019 having worse than seasonal revenue trends. Unfortunately, we do not have any unique insights to forecast the duration or depth of the slowdown but with most third-party economists continuing to forecast global GDP at just under a 3 percent range, you would have to believe, the second half of 2019 will be stronger than the first half.

Overall, we believe that we are strategically positioned to capture rapid growth in emerging markets through our strong position in Greater China (China, Hong Kong and Taiwan), which represented 39% of our revenue in 2018, compared to 41% of our revenue in 2017, and in Asia Pacific, which represented 29% of our revenue in 2018, compared to 27% of our revenue in 2017.

Please also refer to Item 5.A. Operating Results of this Annual Report on Form 20-F for further discussion of trend information.

E. Off-balance Sheet Arrangements

As of December 31, 2018, we had no material off-balance sheet arrangements.

F. Tabular Disclosure of Contractual Obligations

Presented below is a summary of our contractual obligations as of December 31, 2018.

($ in millions)Total201920202021202220232024 and thereafter
Long-term and short-term debt (1)7,4001,1506001,3501,4009002,000
Capital lease obligations272112219
Operating leases156433524131130
Interest on the notes (2)1,328281270230193124230
Long-term purchase contracts33323071183110
Total contractual cash obligations (2)(3)(4)9,2441,7069771,6231,6111,0382,289
(1)The amounts noted herein represent contractual payments of principal only.
(2)The cash interest on the notes was determined on the basis of contractual agreed interest rates for other debt instruments.
(3)As of December 31, 2018, we had reserves of $179 million recorded for uncertain tax positions, including interest and penalties. We are not including this amount in the long-term contractual obligations table presented because of the difficulty in making reasonably reliable estimates of the timing of cash settlements, if any, with the respective taxing authorities.
(4)Certain of these obligations are denominated in currencies other than U.S. dollars, and have been translated from foreign currencies into U.S. dollars based on an aggregate average rate of $1.1794 per €1.00, in effect at December 31, 2018. As a result, the actual payments will vary based on any change in exchange rate.

Our debt instruments had accrued interest of $31 million as of December 31, 2018 (December 31, 2017: $35 million).

In addition to the above obligations, we enter into a variety of agreements in the normal course of business, containing provisions that certain penalties may be charged if we do not fulfill our commitments. It is not possible to predict with certainty the maximum potential amount of future payments under these or similar provisions due to the conditional nature of our obligations and the unique facts and circumstances involved in each particular case. Historically, payments pursuant to such provisions have not been material and we believe that any future payments required pursuant to such provisions would not have a material adverse effect on our consolidated financial condition. However, such payments may be material to our Consolidated Statement of Operations for a specific period.

We sponsor pension plans in many countries in accordance with legal requirements, customs and the local situation in the countries involved. These are defined-benefit pension plans, defined contribution pension plans and multi-employer plans. Contributions to funded pension plans are made as necessary, to provide sufficient assets to meet future benefits payable to plan participants. These contributions are determined by various factors, including funded status, legal and tax considerations and local customs. The expected cash outflows in 2019 and subsequent years are uncertain and may change as a consequence of statutory funding requirements as well as changes in actual versus currently assumed discount rates, estimations of compensation increases and returns on pension plan assets.

G. Safe Harbor

This Annual Report includes forward-looking statements. When used in this Annual Report, the words “anticipate”, “believe”, “estimate”, “forecast”, “expect”, “intend”, “plan” and “project” and similar expressions, as they relate to us, our management or third parties, identify forward-looking statements. Forward-looking statements include statements regarding our business strategy, financial condition, results of operations and market data, as well as any other statements that are not historical facts. These statements reflect beliefs of our management, as well as assumptions made by our management and information currently available to us. Although we believe that these beliefs and assumptions are reasonable, these statements are subject to numerous factors, risks and uncertainties that could cause actual outcomes and results to be materially different from those projected. These factors, risks and uncertainties expressly qualify all subsequent oral and written forward-looking statements attributable to us or persons acting on our behalf and include, in addition to those listed under Part I, Item 3.D. Risk Factors and elsewhere in this Annual Report, the following:

•market demand and semiconductor industry conditions;
•our ability to successfully introduce new technologies and products;
•the demand for the goods into which our products are incorporated;
•trade disputes between the U.S. and China, potential increase of barriers to international trade and resulting disruptions to our established supply chains;
•our ability to generate sufficient cash, raise sufficient capital or refinance our debt at or before maturity to meet both our debt service and research and development and capital investment requirements;
•our ability to accurately estimate demand and match our production capacity accordingly or obtain supplies from third-party producers;
•our access to production from third-party outsourcing partners, and any events that might affect their business or our relationship with them;
•our ability to secure adequate and timely supply of equipment and materials from suppliers;
•our ability to avoid operational problems and product defects and, if such issues were to arise, to rectify them quickly;
•our ability to form strategic partnerships and joint ventures and successfully cooperate with our alliance partners;
•our ability to win competitive bid selection processes;
•our ability to develop products for use in our customers’ equipment and products;
•our ability to successfully hire and retain key management and senior product engineers; and
•our ability to maintain good relationships with our suppliers.

We do not assume any obligation to update any forward-looking statements and disclaim any obligation to update our view of any risks or uncertainties described herein or to publicly announce the result of any revisions to the forward-looking statements made in this Annual Report, except as required by law.

In addition, this Annual Report contains information concerning the semiconductor industry and business segments generally, which is forward-looking in nature and is based on a variety of assumptions regarding the ways in which the semiconductor industry, our market and business segments will develop. We have based these assumptions on information currently available to us, including through the market research and industry reports referred to in this Annual Report. If any one or more of these assumptions turn out to be incorrect, actual market results may differ from those predicted. While we do not know what impact any such differences may have on our business, if there are such differences, they could have a material adverse effect on our future results of operations and financial condition, and the trading price of our common stock.

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