Allison Transmission Holdings Inc (ALSN) FY 2021 MD&A

ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion contains forward-looking statements regarding industry trends, our expectations regarding our future performance, liquidity and capital resources and other non-historical statements that involve risks and uncertainties. Our actual results may differ materially from those discussed in or implied by the forward-looking statements as a result of various factors, including, without limitation, those set forth under Part I, Item 1A, “Risk Factors,” and other matters included elsewhere in this Annual Report on Form 10-K. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K.

This section of this Annual Report on Form 10-K generally discusses 2021 and 2020 items and year-over-year comparisons between 2021 and 2020. A detailed discussion of 2019 items and year-over-year comparisons between 2020 and 2019 that are not included in this Annual Report on Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2020, as filed with the SEC on February 18, 2021.

Overview

We design and manufacture vehicle propulsion solutions, including commercial-duty on-highway, off-highway and defense fully automatic transmissions and electric hybrid and fully electric systems. The business was founded in 1915 and has been headquartered in Indianapolis, Indiana since inception. Allison is traded on the New York Stock Exchange under the symbol, “ALSN”.

We have approximately 3,400 employees. Although approximately 76% of revenues were generated in North America in 2021, we have a global presence by serving customers in Asia, Europe, South America and Africa. We serve customers through an independent network of approximately 1,400 independent distributor and dealer locations worldwide.

Trends Impacting Our Business

Throughout 2021, the COVID-19 pandemic continued to cause supply chain, labor and raw material constraints that created volatility in our business performance and impacted global markets and supply chains. As a result, we experienced, and expect to continue to experience, raw material and component part price inflation, increased freight and logistics costs and increased overtime expense as a result of labor shortages. In addition, despite increased customer demand our net sales for 2021 were negatively impacted as a result of our customers’ inability to secure components from the broader commercial vehicle supply base which resulted in reduced commercial vehicle build schedules. We expect that commercial vehicle build schedules will continue to be negatively impacted by the availability of components in 2022.

To limit the spread of COVID-19, governments continue to take various actions including the administration or mandate of vaccinations, travel bans and restrictions, quarantines, curfews, stay-at-home orders, social distancing guidelines and business shutdowns and closures. We are also continuing to take a variety of measures to promote the safety and security of our employees and to maintain operations with as minimal impact as possible to our stakeholders, and as a result, we have been able to continue our manufacturing operations and deliver our products to customers.

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Full Year 2021 and 2020 Net Sales by End Market (in millions)

North America On-Highway end market net sales were up 9% for the year ended December 31, 2021 compared to the year ended December 31, 2020, principally driven by the recovery in customer demand following the pandemic-related disruptions experienced in 2020 and price increases on certain products.

North America Off-Highway end market net sales were up $45 million for the year ended December 31, 2021 compared to the year ended December 31, 2020, principally driven by higher demand for hydraulic fracturing applications and price increases on certain products.

Defense end market net sales were up 2% for the year ended December 31, 2021 compared to the year ended December 31, 2020, principally driven by higher demand for Tracked vehicle applications and price increases on certain products, partially offset by lower Wheeled vehicle demand.

Outside North America On-Highway end market net sales were up 36% for the year ended December 31, 2021 compared to the year ended December 31, 2020, principally driven by the recovery in customer demand following the pandemic-related disruptions experienced in 2020, the execution of growth initiatives and price increases on certain products.

Outside North America Off-Highway end market net sales were up 36% for the year ended December 31, 2021 compared to the year ended December 31, 2020, principally driven by higher demand in the mining, energy and construction sectors and price increases on certain products.

Service Parts, Support Equipment and Other end market net sales were up 11% for the year ended December 31, 2021 compared to the year ended December 31, 2020, principally driven by higher demand for service parts and support equipment and price increases on certain products.

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Key Components of our Results of Operations

Net sales

We generate our net sales primarily from the sale of vehicle propulsion solutions, service and component parts, support equipment, defense kits, engineering services, royalties and extended transmission coverage to a wide array of OEMs, distributors and the U.S. government. Sales are recorded in accordance with the terms of the contract, net of provisions for customer allowances and other rebates.

Cost of sales

Our primary components of cost of sales are purchased parts, the overhead expense related to our manufacturing operations and direct labor associated with the manufacture and assembly of vehicle propulsion solutions and parts. For the year ended December 31, 2021, direct material costs were approximately 68%, overhead costs were approximately 24% and direct labor costs were approximately 8% of total cost of sales. We are subject to changes in our cost of sales caused by movements in underlying commodity prices. We seek to hedge against this risk by using LTAs. See Part II, Item 7A, “Quantitative and Qualitative Disclosures about Market Risk—Commodity Price Risk” included in this Annual Report on Form 10-K.

Selling, general and administrative

The principal components of our selling, general and administrative expenses are salaries and benefits for our office personnel, advertising and promotional expenses, product warranty expense, expenses relating to certain information technology systems and amortization of our intangible assets.

Engineering — research and development

We incur costs in connection with research and development programs that are expected to contribute to future earnings. Such costs are expensed as incurred.

Non-GAAP Financial Measures

We use Adjusted Earnings before Interest, Taxes, Depreciation, and Amortization (“EBITDA”) and Adjusted EBITDA as a percent of net sales to measure our operating profitability. We believe that Adjusted EBITDA and Adjusted EBITDA as a percent of net sales provide management, investors and creditors with useful measures of the operational results of our business and increase the period-to-period comparability of our operating profitability and comparability with other companies. Adjusted EBITDA as a percent of net sales is also used in the calculation of management’s incentive compensation program. The most directly comparable GAAP measure to Adjusted EBITDA and Adjusted EBITDA as a percent of net sales is Net income and Net income as a percent of net sales, respectively. Adjusted EBITDA is calculated as earnings before interest expense, net, income tax expense, amortization of intangible assets, depreciation of property, plant and equipment and other adjustments as defined by the Second Amended and Restated Credit Agreement dated as of March 29, 2019 as amended (the “Credit Agreement”) governing ATI's term loan facility due March 2026 (“Term Loan”). Adjusted EBITDA as a percent of net sales is calculated as Adjusted EBITDA divided by net sales.

We use Adjusted free cash flow to evaluate the amount of cash generated by our business that, after the capital investment needed to maintain and grow our business and certain mandatory debt service requirements, can be used for repayment of debt, stockholder distributions and strategic opportunities, including investing in our business. We believe that Adjusted free cash flow enhances the understanding of the cash flows of our business for management, investors and creditors. Adjusted free cash flow is also used in the calculation of management’s incentive compensation program. The most directly comparable GAAP measure to Adjusted free cash flow is Net cash provided by operating activities. Adjusted free cash flow is calculated as Net cash provided by operating activities, excluding non-recurring restructuring charges, after additions of long-lived assets.

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The following is a reconciliation of Net income and Net income as a percent of net sales to Adjusted EBITDA and Adjusted EBITDA as a percent of net sales and a reconciliation of Net cash provided by operating activities to Adjusted free cash flow:

(a)
Represents stock-based compensation expense (recorded in Cost of sales, Selling, general and administrative, and Engineering – research and development).

(b)
Represents a gain (recorded in Other income (expense), net) related to an investment in the common stock of Jing-Jin Electric Technologies Co. Ltd.

(c)
Represents gains (recorded in Other income (expense), net) related to investments in co-development agreements to expand our position in transmission technologies.

(d)
Represents (adjustments) charges (recorded in Cost of sales) related to a 2018 to 2021 retirement incentive program for certain employees represented by the International Union, United Automobile, Aerospace and Agricultural Implement Workers of America (“UAW”) pursuant to the UAW Local 933 collective bargaining agreement effective through November 2023.

(e)
Represents expenses (recorded in Selling, general and administrative and Engineering - research and development) for earnouts related to our acquisition of Vantage Power Limited.

(f)
Represents restructuring and pension plan settlement charges (recorded in Cost of sales, Selling, general and administrative, Engineering - research and development, and Other income (expense), net) related to voluntary and involuntary separation programs for both hourly and salaried employees in 2020.

(g)
Represents expenses (recorded in Other income (expense), net) related to the redemption of ATI’s 5.0% Senior Notes due 2024 (“5.0% Senior Notes”) in the fourth quarter of 2020, the refinancing of the prior term loan due 2022 ("Prior Term Loan") and prior revolving credit facility due 2021 ("Prior Revolving Credit Facility") in the first quarter of 2019, and the repricing of the Term Loan in the fourth quarter of 2019.

(h)
Represents losses (recorded in Other income (expense), net) on intercompany financing transactions related to investments in plant assets for our India facility.

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(i)
Represents an environmental remediation benefit (recorded in Selling, general and administrative) related to reduction of the liability for ongoing environmental remediation operating, monitoring and maintenance activities at our Indianapolis, Indiana manufacturing facilities.

(j)
Represents charges (recorded in Selling, general and administrative) associated with the impairment of long-lived assets related to the production of the TC10 transmission.

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Results of Operations

Throughout 2021, the COVID-19 pandemic continued to cause supply chain, labor, freight and raw material constraints that created volatility in our business performance and impacted global markets. As a result, we experienced, and expect to continue to experience, raw material and component part price inflation, increased freight and logistics costs and increased overtime expense as a result of labor shortages. See “Trends Impacting our Business” above for additional information on the impact of the COVID-19 pandemic on our results of operations.

The following table sets forth certain financial information for the years ended December 31, 2021 and 2020. The following table and discussion should be read in conjunction with the information contained in our consolidated financial statements and the notes thereto included in Part II, Item 8. of this Annual Report on Form 10-K.

Comparison of years ended December 31, 2021 and 2020

Net sales

Net sales for the year ended December 31, 2021 were $2,402 million compared to $2,081 million for the year ended December 31, 2020, an increase of 15%. The increase was principally driven by a $101 million, or 36%, increase in net sales in the Outside North America On-Highway end market principally driven by the recovery in customer demand following the pandemic-related disruptions experienced in 2020, the execution of growth initiatives and price increases on certain products, a $96 million, or 9%, increase in net sales in the North America On-Highway end market principally driven by the recovery in customer demand following the pandemic-related disruptions experienced in 2020 and price increases on certain products, a $53 million, or 11%, increase in net sales in the Service Parts, Support Equipment and Other end market principally driven by higher demand for service parts and support equipment and price increases on certain products, a $45 million, or 346%, increase in net sales in the North America Off-Highway end market principally driven by higher demand for hydraulic fracturing applications and price increases on certain products, a $22 million, or 36%, increase in net sales in the Outside North America Off-Highway end market principally driven by higher demand in the mining, energy and construction sectors and price increases on certain products and a $4 million, or 2%, increase in net sales in the Defense end market principally driven by higher demand for Tracked vehicle applications and price increases on certain products, partially offset by lower Wheeled vehicle demand.

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Cost of sales

Cost of sales for the year ended December 31, 2021 was $1,257 million compared to $1,083 million for the year ended December 31, 2020, an increase of 16%. The increase was principally driven by increased direct material and manufacturing expense commensurate with increased net sales, unfavorable material costs and increased incentive compensation expense, partially offset by UAW retirement incentive program expense in 2020 that did not reoccur in 2021 and restructuring charges in 2020 that did not reoccur in 2021.

Gross profit

Gross profit for the year ended December 31, 2021 was $1,145 million compared to $998 million for the year ended December 31, 2020, an increase of 15%. The increase was principally driven by $211 million related to increased net sales, $35 million of price increases on certain products, $7 million related to UAW retirement incentive program expense in 2020 that did not reoccur in 2021 and $5 million of restructuring charges in 2020 that did not reoccur in 2021, partially offset by $52 million of unfavorable material costs, $43 million of higher manufacturing expense commensurate with increased net sales and $18 million of higher incentive compensation expense. Gross profit as a percent of net sales for the year ended December 31, 2021 decreased 30 basis points compared to the same period in 2020 principally driven by unfavorable material costs and higher incentive compensation expense, partially offset by increased net sales, price increases on certain products, UAW retirement incentive program expenses in 2020 that did not reoccur in 2021 and restructuring charges in the second quarter of 2020 that did not reoccur in 2021.

Selling, general and administrative

Selling, general and administrative expenses for the year ended December 31, 2021 were $305 million compared to $317 million for the year ended December 31, 2020, a decrease of 4%. The decrease was principally driven by unfavorable product warranty adjustments in 2020 that did not reoccur in 2021, $6 million of lower intangible amortization expense and $4 million of lower stock-based compensation expense, partially offset by higher incentive compensation expense and higher commercial activities spending.

Engineering — research and development

Engineering expenses for the year ended December 31, 2021 were $171 million compared to $147 million for the year ended December 31, 2020, an increase of 16%. The increase was principally driven by increased product initiatives spending and higher incentive compensation expense, partially offset by $4 million of restructuring charges in 2020 that did not reoccur in 2021.

Interest expense, net

Interest expense, net for the year ended December 31, 2021 was $116 million compared to $137 million for the year ended December 31, 2020, a decrease of 15%. The decrease was principally driven by $11 million of decreased interest expense due to lower interest rates as a result of our long-term debt refinancing in the fourth quarter of 2020 that extended maturities at lower fixed interest rates, $6 million of deferred financing costs written off related to the long-term debt refinancing in the fourth quarter of 2020 that did not reoccur in 2021, $3 million of lower interest expense on ATI’s Term Loan due to lower variable interest rates and $2 million of decreased interest expense on ATI’s Revolving Credit Facility, partially offset by $4 million of increased interest expense on interest rate hedges.

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Other income (expense), net

Other income (expense), net for the year ended December 31, 2021 was $19 million compared to ($4) million for the year ended December 31, 2020. The change was principally driven by $13 million of expenses related to the redemption of ATI's 5.0% Senior Notes in the fourth quarter of 2020 that did not reoccur in 2021, a $4 million unrealized gain on marketable securities, a $4 million gain related to technology-related investments, $3 million of favorable foreign exchange on intercompany financing and a $2 million settlement charge related to the settlement of pension obligations as a result of our voluntary and involuntary separation programs recognized in 2020 that did not reoccur in 2021, partially offset by $3 million of reduced post-retirement benefit plan credits.

Income tax expense

Income tax expense for the year ended December 31, 2021 was $130 million resulting in an effective tax rate of 23%, compared to $94 million of income tax expense and an effective tax rate of 24% for the year ended December 31, 2020. The increase in income tax expense was principally driven by increased taxable income. The decrease in the effective tax rate was principally driven by increased estimated U.S. federal income tax deductions.

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Liquidity and Capital Resources

We generate cash primarily from operations to fund our operating, investing and financing activities. Our principal uses of cash are operating expenses, capital expenditures, working capital needs, debt service, dividends on common stock, stock repurchases, and strategic growth initiatives, including investments, acquisitions and collaborations. Our ability to generate cash in the future and our future uses of cash are subject to general economic, financial, competitive, legislative, regulatory and other factors that may be beyond our control. We had total available cash and cash equivalents of $127 million and $310 million as of December 31, 2021 and 2020, respectively. Of the available cash and cash equivalents, all of the $127 million was deposited in operating accounts as of December 31, 2021, compared to $150 million deposited in operating accounts and $160 million invested in U.S. government backed securities as of December 31, 2020.

As of December 31, 2021, the total of cash and cash equivalents held by foreign subsidiaries was $84 million, the majority of which was located in China and Europe. We manage our worldwide cash requirements considering available funds among the subsidiaries through which we conduct our business and the cost effectiveness with which those funds can be accessed. As a result, we do not currently anticipate that local liquidity restrictions will preclude us from funding our targeted expectations or operating needs with local resources.

We have not recognized any deferred tax liabilities associated with earnings in foreign subsidiaries, except for our subsidiary located in China, as they are intended to be permanently reinvested and used to support foreign operations or have no associated tax requirements. We have recorded a deferred tax liability of $3 million for the tax liability associated with the remittance of previously taxed income and unremitted earnings for our subsidiary located in China. The remaining deferred tax liabilities, if recorded, related to unremitted earnings that are indefinitely reinvested are not material.

Our liquidity requirements are significant, primarily due to our debt service requirements. As of December 31, 2021, we had $631 million of indebtedness associated with ATI’s Term Loan, $400 million of indebtedness associated with ATI’s 4.75% Senior Notes, $500 million of indebtedness associated with ATI’s 5.875% Senior Notes and $1,000 million of indebtedness associated with ATI’s 3.75% Senior Notes. Short-term and long-term debt service liquidity requirements consist of $2 million of minimum required quarterly principal payments on ATI’s Term Loan through its maturity date of March 2026 and periodic interest payments on ATI’s Term Loan and the Senior Notes. There are no required quarterly principal payments on ATI’s Senior Notes. Long-term debt service liquidity requirements also consist of the payment in full of any remaining principal balance of ATI’s Term Loan and the Senior Notes upon their respective maturity dates.

We made $7 million and $6 million of principal payments on the Term Loan during the years ended December 31, 2021 and 2020, respectively. Our ability to make payments on and refinance our indebtedness and to fund planned capital expenditures and growth initiatives will depend on our ability to generate cash in the future.

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In November 2020, the Company and ATI entered into an amendment to the Credit Agreement to increase the commitments under the revolving credit facility due September 2025 ("Revolving Credit Facility" and, together with the Term Loan, the “Senior Secured Credit Facility”) by $50 million. The amendment also extended the Revolving Credit Facility termination date from September 2024 to September 2025. The Senior Secured Credit Facility, as amended, provides for a $650 million Revolving Credit Facility, net of an allowance for up to $75 million in outstanding letters of credit commitments. As of December 31, 2021, we had $645 million available under the Revolving Credit Facility, net of $5 million in letters of credit. If we have commitments outstanding on the Revolving Credit Facility at the end of a fiscal quarter, the Senior Secured Credit Facility requires us to maintain a specified maximum first lien net leverage ratio of 5.50x. Additionally, within the terms of the Senior Secured Credit Facility, a first lien net leverage ratio at or below 4.00x results in the elimination of excess cash flow payments on the Senior Secured Credit Facility for the applicable year. As of December 31, 2021, our first lien net leverage ratio was 0.60x. The Senior Secured Credit Facility also provides certain financial incentives based on our first lien net leverage ratio. A first lien net leverage ratio at or below 4.00x and above 3.50x results in a 25 basis point reduction to the applicable margin on the Revolving Credit Facility. A first lien net leverage ratio at or below 3.50x results in an additional 25 basis point reduction to the applicable margin on the Revolving Credit Facility. These reductions remain in effect as long as we achieve a first lien net leverage ratio at or below the related threshold.

In addition, the Credit Agreement includes, among other things, customary restrictions (subject to certain exceptions) on our ability to incur certain indebtedness, grant certain liens, make certain investments, engage in acquisitions, consolidations and mergers, declare or pay certain dividends, and repurchase shares of our common stock. The indentures governing the Senior Notes contain negative covenants restricting or limiting our ability to, among other things, incur or guarantee additional indebtedness, incur liens, pay dividends on, redeem or repurchase our capital stock, make certain investments, permit payment or dividend restrictions on certain of our subsidiaries, sell assets, engage in certain transactions with affiliates, and consolidate or merge or sell all or substantially all of our assets. As of December 31, 2021, we are in compliance with all covenants under the Senior Secured Credit Facility and indentures governing the Senior Notes.

Our credit ratings are reviewed by Moody’s Investors Service (“Moody’s”) and Fitch Ratings (“Fitch”), and in 2021, we received credit ratings upgrades from Moody's and Fitch. Moody’s rates our corporate credit at ‘Ba1’, the Term Loan at ‘Baa2’, the 4.75% Senior Notes at ‘Ba2’, the 5.875% Senior Notes at 'Ba2', and the 3.75% Senior Notes at ‘Ba2’. Fitch rates our corporate credit at ‘BB’, the Term Loan at ‘BBB-’, the 4.75% Senior Notes at ‘BB’, the 5.875% Senior Notes at 'BB' and the 3.75% Senior Notes at ‘BB’.

We anticipate that our capital expenditures in 2022 will be in line with 2021 and expect increased cash income taxes as a result of lower deductions in 2022 related to our intangible assets.

During 2021, we repurchased approximately $513 million of our common stock under the Repurchase Program. All of the repurchase transactions during 2021 were settled in cash during the same period. As of December 31, 2021, we had approximately $314 million available under the Repurchase Program.

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The following table shows our sources and uses of funds for the years ended December 31, 2021, 2020 and 2019 (in millions):

Generally, cash provided by operating activities has been adequate to fund our operations. We have significant liquidity, including $127 million of cash and cash equivalents and $645 million available under the Revolving Credit Facility, net of $5 million in letters of credit, as of December 31, 2021. At this time, we believe cash provided by operating activities, cash and cash equivalents and borrowing capacity under the Senior Secured Credit Facility will be sufficient to meet our known and anticipated cash requirements for the next twelve months and thereafter.

Cash provided by operating activities

Operating activities for the year ended December 31, 2021 generated $635 million of cash compared to $561 million for the year ended December 31, 2020. The increase was principally driven by higher gross profit, lower cash incentive compensation payments and lower cash interest payments, partially offset by higher operating working capital requirements, higher cash income taxes and increased product initiatives spending.

Cash used for investing activities

Investing activities for the year ended December 31, 2021 used $212 million of cash compared to $111 million for the year ended December 31, 2020. The increase was principally driven by a $60 million increase in capital expenditures, a $41 million investment in marketable securities and a $4 million net working capital settlement related to the acquisition of Walker Die Casting in 2020 that did not reoccur in 2021, partially offset by $4 million of proceeds from technology-related investments in 2021.

Cash used for financing activities

Financing activities for the year ended December 31, 2021 used $604 million of cash compared to $335 million for the year ended December 31, 2020. The increase was principally driven by $288 million of increased stock repurchases under the Repurchase Program and $3 million of increased dividend payments, partially offset by payments related to long-term debt refinancing in 2020 that did not reoccur in 2021.

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Critical Accounting Policies and Significant Accounting Estimates

The preparation of the consolidated financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of some assets and liabilities and, in some instances, the reported amounts of net sales and expenses during the applicable reporting period. Differences between actual amounts and estimates are recorded in the period identified. Estimates can require a significant amount of judgment, and a different set of judgments could result in changes to our reported results. A summary of our critical accounting estimates is included below.

Revenue Recognition

Revenue recognition contains uncertainties because it requires management to make assumptions and to apply judgment to estimate the amount of sales incentives and provision for government price reductions. Distributor and customer sales incentives, consisting of allowances and other rebates, are estimated at the time of sale based upon history and experience and are recorded as a reduction to net sales. Incentive programs are generally product specific or region specific. Some factors used in estimating the cost of incentives include the number of transmissions that will be affected by the incentive program and the rate of acceptance of any incentive program. If the actual number of affected transmissions differs from this estimate, or if a different mix of incentives is actually paid, the impact on net sales would be recorded in the period that the change was identified. Assuming our current mix of sales incentives, a 10% change in sales incentives would correspondingly change our earnings by approximately $9 million.

Under terms of certain previous U.S. government contracts, there were price reduction clauses and provisions for potential price reductions which are estimated at the time of sale based upon history and experience, and finalized after completion of U.S. government audits. Given our current price reduction reserve for government contracts, a 10% adjustment in our price reduction reserve would correspondingly change our earnings by approximately $6 million. Since 2014, Allison contracts with the U.S. Government have generally been firm, fixed price contracts and therefore have not required re-calculation of pricing based on cost principles.

Further information is provided in "NOTE 2. Summary of Significant Accounting Policies” of Notes to Consolidated Financial Statements included in Part II, Item 8., of this Annual Report on Form 10-K.

Goodwill and Other Intangible Assets

We have elected to perform our annual impairment tests for goodwill and indefinite lived intangible assets on October 31 of every year using a multi-step impairment test. In Step 0, we have the option to evaluate various qualitative factors to determine the likelihood of impairment. If we determine that the fair value is more likely than not less than the carrying value, then we are required to perform Step 1. If we do not elect to perform Step 0, we can voluntarily proceed directly to Step 1. In Step 1, we perform a quantitative analysis to compare the fair value to our carrying value. If the fair value exceeds the carrying value, no impairment is recorded, and we are not required to perform further testing. If the carrying value exceeds fair value, we would record an impairment loss equal to the difference.

A qualitative assessment contains uncertainties because it requires management to make assumptions and to apply judgment to assess business changes, economic outlook, financial trends and forecasts, growth rates, credit ratings, equity ratings, discount rates, industry data and other relevant qualitative factors.

A quantitative analysis contains uncertainties because it is performed utilizing a discounted cash flow model which includes key assumptions, such as financial forecasts; net sales growth derived from market information, industry reports, marketing programs and future new product introductions; operating margin improvements derived

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from cost reduction programs and fixed cost leverage driven by higher sales volumes; and a risk-adjusted discount rate.

Goodwill represents the excess of purchase price paid over the fair value of net assets acquired. In accordance with the Financial Accounting Standards Board’s (“FASB”) authoritative accounting guidance on goodwill, we do not amortize goodwill but rather evaluate it for impairment on an annual basis, or more often if events or circumstances change that could cause goodwill to become impaired. Goodwill is tested for impairment at the reporting unit level, which is the same as our one operating and reportable segment. We do not aggregate any components into our reporting unit.

Goodwill impairment testing for 2021 was performed using the Step 0 analysis by assessing certain qualitative trends and factors. These trends and factors were compared to, and based on, the assumptions used in prior years. After reviewing the various qualitative factors mentioned above, our 2021 annual goodwill impairment test indicated that the fair value for the reporting unit more likely than not exceeded its carrying value, indicating no impairment.

Other intangible assets have both indefinite and finite useful lives. Intangible assets with indefinite useful lives are not amortized but are tested annually for impairment, or more often if events or circumstances change that could cause intangible assets with indefinite useful lives to become impaired. After reviewing the various qualitative factors mentioned above, our annual 2021 indefinite lived intangible assets impairment tests, as of October 31, 2021, indicated that the fair value of our indefinite lived intangible assets more likely than not exceeded their respective carrying values, indicating no impairment.

Intangible assets with finite lives are amortized over their estimated useful lives and reviewed for impairment when circumstances change that would create a triggering event. Customer relationships are amortized over the life in which expected benefits are to be consumed. The other remaining finite life intangibles are amortized on a straight-line basis over their useful lives. We evaluate the remaining useful life of the other intangible assets on a periodic basis to determine whether events or circumstances warrant a revision to the remaining useful life. Assumptions and estimates about future values and remaining useful lives of our intangible and other long-lived assets are complex and subjective. Such assumptions and estimates can be affected by a variety of factors, including external factors such as industry and economic trends, and internal factors, such as changes in our business strategy and internal forecasts. Although management believes the historical assumptions and estimates are reasonable and appropriate, different assumptions and estimates could materially impact our reported financial results. Further information is provided in "NOTE 6. Goodwill and Other Intangible Assets” of Notes to Consolidated Financial Statements included in Part II, Item 8., of this Annual Report on Form 10-K.

Impairment of Long-Lived Assets

The carrying value of long-lived assets is evaluated whenever events or circumstances indicate that the carrying value of a long-lived asset may not be recoverable. Events or circumstances that would result in an impairment review primarily include a significant change in the use of an asset, or the planned sale or disposal of an asset. The asset would be considered impaired when there is no future use planned for the asset or the future net undiscounted cash flows generated by the asset or asset group are less than its carrying value. An impairment loss would be recognized based on the amount by which the carrying value exceeds fair value.

Assumptions and estimates used to determine cash flows in the evaluation of impairment and the fair values used to determine the impairment are subject to a degree of judgment and complexity. Any changes to the assumptions and estimates resulting from changes in actual results or market conditions from those anticipated may affect the carrying value of long-lived assets and could result in an impairment charge.

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Warranty

Provisions for estimated expenses related to product warranties are made at the time products are sold. Warranty claims arise when a transmission fails while in service during the relevant warranty period. The warranty reserve is adjusted in Selling, general and administrative expense based on our current and historical warranty claims paid and associated repair costs. These estimates are established using historical information including the nature, frequency, and average cost of warranty claims and are adjusted as actual information becomes available. From time to time, we may initiate a specific field action program. As a result of the uncertainty surrounding the nature and frequency of specific field action programs, the liability for such programs is recorded when we commit to an action. We review and assess the liability for these programs on a quarterly basis. We also assess our ability to recover certain costs from our suppliers and record a receivable from the supplier when we believe a recovery is probable. Warranty costs may differ from those estimated if actual claim rates are higher or lower than our historical rates. Further information is provided in "NOTE 10. Product Warranty Liabilities” of Notes to Consolidated Financial Statements included in Part II, Item 8., of this Annual Report on Form 10-K which contains a summary of the activity in our warranty liability account for 2021, 2020 and 2019, including adjustments to pre-existing warranties.

Pension and Post-retirement Benefit Plans

Pension and OPEB costs are based upon various actuarial assumptions and methodologies as prescribed by authoritative accounting guidance. These assumptions include discount rates, expected return on plan assets, health care cost trend rates, inflation, rate of compensation increases, population demographics, mortality rates and other factors. We review all actuarial assumptions on an annual basis.

A change in the discount rate can have a significant impact on determining our benefit obligations. Our current discount rate is determined by matching the plans’ projected cash flows to a yield curve based on long-term, fixed income debt instruments available as of the measurement date of December 31, 2021. The effect of a one percentage point decrease in the assumed discount rate would result in an increase in the December 31, 2021 defined benefit pension plans obligation of approximately $27 million. Similarly, a one percentage point decrease in the assumed discount rate would result in an increase in the December 31, 2021 OPEB obligation of approximately $15 million.

Further information is provided in "NOTE 15. Employee Benefit Plans” of Notes to Consolidated Financial Statements included in Part II, Item 8., of this Annual Report on Form 10-K, which contains our review on various actuarial assumptions.

Income Taxes

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the expected future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. The future tax benefits associated with operating loss and tax credit carryforwards are recognized as deferred tax assets. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. When releasing income tax effects from accumulated other comprehensive loss, we utilize the portfolio securities approach.

As of December 31, 2021, our U.S. federal income tax deductions related to our intangible assets were approximately $330 million in 2021 and are expected to be approximately $197 million in 2022 and approximately $10 million annually through 2034. Excluding our intangible asset deductions, our expected tax payments would have increased by approximately $77 million for the year ended December 31, 2021.

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The need to establish a valuation allowance against the deferred tax assets is assessed at least quarterly based on a more-likely-than-not realization threshold, in accordance with the FASB authoritative accounting guidance on income taxes. Appropriate consideration is given to all positive and negative evidence related to that realization. This assessment considers, among other matters, the nature, frequency and severity of recent losses, forecasts of future profitability, the duration of statutory carryforward periods, and experience with tax attributes expiring unused and tax planning alternatives. The weight given to these considerations depends upon the degree to which they can be objectively verified.

Further information on income taxes is provided in "NOTE 16. Income Taxes” of Notes to Consolidated Financial Statements included in Part II, Item 8., of this Annual Report on Form 10-K.

Business Combinations

We use the acquisition method to account for business combinations. The assets acquired and liabilities assumed are recorded at their respective estimated fair value at the date of acquisition. Any excess purchase price over the fair values of the acquired net assets is recorded as goodwill. Determining the fair values of assets acquired and liabilities assumed requires management's judgment and includes the use of estimates with respect to timing and amount of future cash flows, market rate assumptions, actuarial assumptions, appropriate discount rates and other relevant factors.

Off-Balance Sheet Arrangements

We are not a party to any off-balance sheet arrangements.

Recently Adopted Accounting Pronouncements

Refer to "NOTE 2. Summary of Significant Accounting Policies” in Part II, Item 8., of this Annual Report on Form 10-K.

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