Avery Dennison Corp (AVY) FY 2022 MD&A
This page reproduces the company's own Item 7 MD&A text from the linked SEC filing. It is filer text, not grepcent analysis, scoring, or investment advice.
Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ORGANIZATION OF INFORMATION
Management’s Discussion and Analysis of Financial Condition and Results of Operations, or MD&A, provides management’s views on our financial condition and results of operations and should be read in conjunction with the Consolidated Financial Statements and related notes thereto, and includes the sections identified below.
| Non-GAAP Financial Measures | 21 |
|---|---|
| Overview and Outlook | 22 |
| Analysis of Results of Operations | 24 |
| Results of Operations by Reportable Segment | 26 |
| Financial Condition | 28 |
| Critical Accounting Estimates | 33 |
| Recent Accounting Requirements | 36 |
NON-GAAP FINANCIAL MEASURES
We report our financial results in conformity with accounting principles generally accepted in the United States of America, or GAAP, and also communicate with investors using certain non-GAAP financial measures. These non-GAAP financial measures are not in accordance with, nor are they a substitute for or superior to, the comparable GAAP financial measures. These non-GAAP financial measures are intended to supplement the presentation of our financial results prepared in accordance with GAAP. Based on feedback from investors and financial analysts, we believe that the supplemental non-GAAP financial measures we provide are useful to their assessments of our performance and operating trends, as well as liquidity.
Our non-GAAP financial measures exclude the impact of certain events, activities or strategic decisions. The accounting effects of these events, activities or decisions, which are included in the GAAP financial measures, may make it more difficult to assess our underlying performance in a single period. By excluding the accounting effects, positive or negative, of certain items (e.g., restructuring charges, outcomes of certain legal proceedings, certain effects of strategic transactions and related costs, losses from debt extinguishments, gains or losses from curtailment or settlement of pension obligations, gains or losses on sales of certain assets, gains or losses on venture investments and other items), we believe that we are providing meaningful supplemental information that facilitates an understanding of our core operating results and liquidity measures. While some of the items we exclude from GAAP financial measures recur, they tend to be disparate in amount, frequency or timing.
We use these non-GAAP financial measures internally to evaluate trends in our underlying performance, as well as to facilitate comparison to the results of competitors for quarters and year-to-date periods, as applicable.
We use the non-GAAP financial measures defined below in this MD&A.
•Sales change ex. currency refers to the increase or decrease in net sales, excluding the estimated impact of foreign currency translation and the reclassification of sales between segments and, where applicable, an extra week in our fiscal year, the calendar shift resulting from the extra week in the prior fiscal year and currency adjustment for transitional reporting of highly inflationary economies. The estimated impact of foreign currency translation is calculated on a constant currency basis, with prior period results translated at current period average exchange rates to exclude the effect of currency fluctuations.
•Organic sales change refers to sales change ex. currency, excluding the estimated impact of acquisitions and product line divestitures.
We believe that sales change ex. currency and organic sales change assist investors in evaluating the sales change from the ongoing activities of our businesses and enhance their ability to evaluate our results from period to period.
•Free cash flow refers to cash flow provided by operating activities, less payments for property, plant and equipment, software and other deferred charges, plus proceeds from sales of property, plant and equipment, plus (minus) net proceeds from insurance and sales (purchases) of investments. Free cash flow is also adjusted for, where applicable, certain acquisition-related transaction costs. We believe that free cash flow assists investors by showing the amount of cash we have available for debt reductions, dividends, share repurchases, and acquisitions.
•Operational working capital as a percentage of annualized current quarter net sales refers to trade accounts receivable and inventories, net of accounts payable, and excludes cash and cash equivalents, short-term borrowings, deferred taxes, other current assets and other current liabilities, as well as net current assets or liabilities held-for-sale divided by annualized current quarter net sales. We believe that operational working capital as a percentage of annualized current quarter net sales assists investors in assessing our working capital
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requirements because it excludes the impact of fluctuations attributable to our financing and other activities (which affect cash and cash equivalents, deferred taxes, other current assets and other current liabilities) that tend to be disparate in amount, frequency or timing, and may increase the volatility of working capital as a percentage of sales from period to period. The items excluded from this measure are not significantly influenced by our day-to-day activities managed at the operating level and do not necessarily reflect the underlying trends in our operations.
OVERVIEW AND OUTLOOK
Fiscal Year
Our fiscal years generally consist of 52 weeks, but every fifth or sixth fiscal year consists of 53 weeks; our 2022 and 2021 fiscal years consisted of 52-week periods ending December 31, 2022 and January 1, 2022, respectively. Our 2020 fiscal year consisted of a 53-week period ending January 2, 2021.
Segment Information
In the fourth quarter of 2022, we changed our operating structure to align with our overall business strategy, and our Chief Executive Officer, who is also our chief operating decision maker, requested changes in the information that he regularly reviews to allocate resources and assess performance. As a result, our fiscal year 2022 results are reported based on our new reportable segments as described in Note 15, "Segment Information." We have recast prior periods to reflect our new operating structure.
Net Sales
The factors impacting reported net sales change, as compared to the prior-year period, are shown in the table below.
| 2022 | 2021 | |||||
|---|---|---|---|---|---|---|
| Reported net sales change | 8 | % | 21 | % | ||
| Foreign currency translation | 6 | (3) | ||||
| Extra week impact | — | 1 | ||||
| Sales change ex. currency(1) | 13 | % | 19 | % | ||
| Acquisitions and product line divestitures | (4) | (3) | ||||
| Organic sales change(1) | 10 | % | 16 | % |
(1) Totals may not sum due to rounding.
In 2022, net sales increased on an organic basis primarily due to pricing actions, partially offset by lower volume/mix. In 2021, net sales increased on an organic basis primarily due to higher volume/mix and recovery from the prior-year impact of COVID-19.
Net Income
Net income increased from approximately $740 million in 2021 to approximately $757 million in 2022. The major factors affecting this increase were:
•The net benefit of pricing, freight, energy and raw material costs, including material re-engineering
•Higher income from acquisitions, net of associated amortization of other intangibles
•Lower transaction and related costs
Offsetting factors:
•Lower volume due to inventory destocking
•Unfavorable foreign currency translation
•Growth investments
•Higher employee-related costs
Acquisitions
Subsequent to our fiscal year-end 2022, in January 2023, we entered into an agreement to acquire Thermopatch, Inc., a New York-based manufacturer specializing in labeling, embellishments, and transfers for the sports, industrial laundry, workwear and hospitality industries. We believe this acquisition will expand the product portfolio in our Solutions Group reportable segment. We expect to complete this acquisition in the first quarter of 2023.
2022 Acquisitions
In January 2022, we completed our acquisitions of TexTrace AG ("TexTrace"), a Switzerland-based technology developer specializing in custom-made woven and knitted RFID products that can be sewn onto or inserted into garments, and Rietveld Serigrafie B.V. and Rietveld Screenprinting Serigrafi Baski Matbaa Tekstil Ithalat Ihracat Sanayi ve Ticaret Limited Sirketi (collectively, "Rietveld"), a Netherlands-based provider of external embellishment solutions and application
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and printing methods for performance brands and team sports in Europe. These acquisitions expanded the product portfolio in our Solutions Group reportable segment. The acquisitions of TexTrace and Rietveld are referred to collectively as the "2022 Acquisitions."
The aggregate purchase consideration for the 2022 Acquisitions was approximately $35 million. We funded the 2022 Acquisitions using cash and commercial paper borrowings. In addition to the cash paid at closing, the sellers in one of these acquisitions are eligible for earn-out payments of up to $30 million, subject to the acquired company achieving certain post-acquisition performance targets. As of the acquisition date, we included an estimate of the fair value of these earn-out payments in the aggregate purchase consideration.
The 2022 Acquisitions were not material, individually or in the aggregate, to the Consolidated Financial Statements.
Vestcom Acquisition
On August 31, 2021, we completed our acquisition of CB Velocity Holdings, LLC (“Vestcom”), an Arkansas-based provider of shelf-edge pricing, productivity and consumer engagement solutions for retailers and consumer packaged goods companies, for purchase consideration of $1.47 billion. We funded this acquisition using cash and proceeds from both commercial paper borrowings and issuances of senior notes. Refer to Note 4, “Debt,” to the Consolidated Financial Statements for more information.
Vestcom’s solutions expanded our position in high value categories and added channel access and data management capabilities to our Solutions Group reportable segment.
Other 2021 Acquisitions
On March 18, 2021, we completed our acquisition of the net assets of ZippyYum, LLC (“ZippyYum”), a California-based developer of software products used in the food service and food preparation industries. This acquisition enhanced the product portfolio in our Solutions Group reportable segment.
On March 1, 2021, we completed our acquisition of the issued and outstanding stock of JDC Solutions, Inc. (“JDC”), a Tennessee-based manufacturer of pressure-sensitive specialty tapes. This acquisition expanded the product portfolio in our Materials Group reportable segment.
The acquisitions of ZippyYum and JDC are referred to collectively as the “Other 2021 Acquisitions.”
The aggregate purchase consideration for the Other 2021 Acquisitions was approximately $43 million. We funded the Other 2021 Acquisitions using cash and commercial paper borrowings. In addition to the cash paid at closing, the sellers in one of these acquisitions are eligible for earn-out payments of up to approximately $13 million subject to the acquired company’s achievement of certain post-acquisition performance targets. As of the acquisition date, we estimated the fair value of these earn-out payments to be approximately $12 million, which was included in the $43 million of aggregate purchase consideration.
The Other 2021 Acquisitions were not material, individually or in the aggregate, to the Consolidated Financial Statements.
Refer to Note 2, “Acquisitions,” to the Consolidated Financial Statements for more information.
Cost Reduction Actions
2019/2020 Actions
During 2022, we recorded $7.3 million in restructuring charges, net of reversals, related to our 2019/2020 actions. These charges consisted of severance and related costs for the reduction of approximately 830 positions and asset impairment charges at numerous locations across our company, reflecting actions in both our reportable segments. The actions in our Materials Group reportable segment were primarily associated with consolidations of its operations in North America and its graphics business in Europe, in part in response to COVID-19. The actions in our Solutions Group reportable segment were primarily related to global headcount and footprint reduction, with some actions accelerated and expanded in response to COVID-19. During 2021, we recorded $13.3 million in restructuring charges, net of reversals, related to our 2019/2020 actions. These charges consisted of severance and related costs for the reduction of approximately 360 positions, as well as asset impairment charges. Our activities related to our 2019/2020 actions began in the fourth quarter of fiscal year 2019 and continued through fiscal year 2022.
Impact of Cost Reduction Actions
In 2022 and 2021, we realized approximately $26 million and $65 million, respectively, in savings from restructuring, net of transition costs, primarily related to our 2019/2020 actions.
Restructuring charges were included in “Other expense (income), net” in the Consolidated Statements of Income. Refer to Note 13, “Cost Reduction Actions,” to the Consolidated Financial Statements for more information.
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Accounting Guidance Updates
Refer to Note 1, “Summary of Significant Accounting Policies,” to the Consolidated Financial Statements for this information.
Cash Flow
| (In millions) | 2022 | 2021 | 2020 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Net cash provided by operating activities | $ | 961.0 | $ | 1,046.8 | $ | 751.3 | |||||
| Purchases of property, plant and equipment | (278.1) | (255.0) | (201.4) | ||||||||
| Purchases of software and other deferred charges | (20.4) | (17.1) | (17.2) | ||||||||
| Proceeds from sales of property, plant and equipment | 2.3 | 1.1 | 9.2 | ||||||||
| Proceeds from insurance and sales (purchases) of investments, net | 1.9 | 3.1 | 5.6 | ||||||||
| Payments for certain acquisition-related transaction costs | .6 | 18.8 | — | ||||||||
| Free cash flow | $ | 667.3 | $ | 797.7 | $ | 547.5 |
In 2022, cash flow provided by operating activities decreased compared to 2021 primarily due to changes in operational working capital, higher incentive compensation payments and the timing of payroll payments, partially offset by higher net income and lower income tax payments, net of refunds. In 2022, free cash flow decreased compared to 2021 primarily due to lower cash provided by operating activities adjusted for payments for certain acquisition-related transaction costs and higher purchases of property, plant and equipment.
Outlook
Certain factors that we believe will contribute to our 2023 results are described below.
•We expect net sales to increase by approximately 0% to 4%, in part reflecting a decrease of approximately 1% from the impact of foreign currency translation.
•We anticipate incremental savings from restructuring actions, net of transition costs, of approximately $45 million.
•We expect our full-year effective tax rate to be in the mid-twenty percent range.
•We expect fixed and IT capital expenditures to be approximately $350 million.
ANALYSIS OF RESULTS OF OPERATIONS
Income before Taxes
| (In millions, except percentages) | 2022 | 2021 | 2020 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Net sales | $ | 9,039.3 | $ | 8,408.3 | $ | 6,971.5 | |||||
| Cost of products sold | 6,635.1 | 6,095.5 | 5,048.2 | ||||||||
| Gross profit | 2,404.2 | 2,312.8 | 1,923.3 | ||||||||
| Marketing, general and administrative expense | 1,330.8 | 1,248.5 | 1,060.5 | ||||||||
| Other expense (income), net | (.6) | 5.6 | 53.6 | ||||||||
| Interest expense | 84.1 | 70.2 | 70.0 | ||||||||
| Other non-operating expense (income), net | (9.4) | (4.1) | 1.9 | ||||||||
| Income before taxes | $ | 999.3 | $ | 992.6 | $ | 737.3 | |||||
| Gross profit margin | 26.6 | % | 27.5 | % | 27.6 | % |
Gross Profit Margin
Gross profit margin in 2022 decreased compared to 2021 primarily due the net impact of higher selling prices, higher raw material costs and higher freight costs, as well as higher employee-related costs, partially offset by higher volume/mix primarily related to the impact of acquisitions.
Gross profit margin in 2021 decreased slightly compared to 2020 primarily reflecting the net impact of higher selling prices, higher raw material costs and higher freight costs, the impact of prior-year temporary cost reduction actions and higher employee-related costs, partially offset by favorable volume/mix and the benefits from productivity initiatives, including temporary cost reduction actions, material re-engineering and savings from restructuring actions, net of transition costs.
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Marketing, General and Administrative Expense
Marketing, general and administrative expense increased in 2022 compared to 2021 primarily due the impact of acquisitions and growth investments, partially offset by the impact of favorable foreign currency translation.
Marketing, general and administrative expense increased in 2021 compared to 2020 primarily due to higher employee-related costs including the impact of acquisitions, growth investments, the impact of prior-year temporary cost reduction actions and unfavorable currency translation, partially offset by lower allowance for credit losses.
Other Expense (Income), Net
| (In millions) | 2022 | 2021 | 2020 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Other expense (income), net by type | |||||||||||
| Restructuring charges: | |||||||||||
| Severance and related costs | $ | 7.6 | $ | 10.5 | $ | 49.1 | |||||
| Asset impairment charges and lease cancellation costs | .1 | 3.1 | 6.2 | ||||||||
| Other items: | |||||||||||
| Transaction and related costs | .3 | 20.9 | 4.2 | ||||||||
| Outcomes of legal proceedings, net | 6.3 | (.4) | — | ||||||||
| Gain on venture investments, net | (13.5) | (23.0) | (5.4) | ||||||||
| (Gain) loss on sales of assets, net | (1.4) | .2 | (.5) | ||||||||
| Gain on sale of product line | — | (5.7) | — | ||||||||
| Other expense (income), net | $ | (.6) | $ | 5.6 | $ | 53.6 |
Refer to Note 13, “Cost Reduction Actions,” to the Consolidated Financial Statements for more information regarding restructuring charges.
Refer to Note 9, “Fair Value Measurements,” to the Consolidated Financial Statements for more information regarding gains on venture investments.
Refer to Note 15, “Segment and Disaggregated Revenue Information,” to the Consolidated Financial Statements for more information regarding outcomes of legal proceedings.
Interest Expense
Interest expense increased by approximately $13.9 million in 2022 compared to 2021, primarily as a result of additional interest from the $800 million of senior notes we issued in August 2021 and higher interest rates on short-term borrowings. Interest expense in 2021 was comparable to 2020.
Net Income and Earnings per Share
| (In millions, except percentages and per share amounts) | 2022 | 2021 | 2020 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Income before taxes | $ | 999.3 | $ | 992.6 | $ | 737.3 | |||||
| Provision for income taxes | 242.2 | 248.6 | 177.7 | ||||||||
| Equity method investment (losses) gains | — | (3.9) | (3.7) | ||||||||
| Net income | $ | 757.1 | $ | 740.1 | $ | 555.9 | |||||
| Net income per common share | $ | 9.28 | $ | 8.93 | $ | 6.67 | |||||
| Net income per common share, assuming dilution | 9.21 | 8.83 | 6.61 | ||||||||
| Effective tax rate | 24.2 | % | 25.0 | % | 24.1 | % |
Provision for Income Taxes
Our effective tax rate in 2022 decreased compared to 2021 primarily due to higher benefits related to the settlement of certain foreign tax audits and the benefit from the interest portion of the Brazil indirect tax credit being adjudicated as non-taxable, partially offset by U.S. federal return-to-provision benefits that were lower than in 2021. Our effective tax rate in 2021 increased compared to 2020 primarily due to lower benefits from decreases in certain tax reserves, including interest and penalties, as a result of closing tax years, and the tax charge related to certain legal proceeding, partially offset by higher benefits from return-to-provision adjustments related to our global intangible low-taxed income ("GILTI") exclusion elections in 2021.
On August 16, 2022, the U.S. government enacted the Inflation Reduction Act ("IRA"), which, among other things, implemented a 15% corporate alternative minimum tax based on the adjusted financial statement income for certain large
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corporations and a 1% excise tax on net share repurchases. The minimum tax and the excise tax, if applicable, are effective for fiscal years beginning after December 31, 2022. We do not expect the IRA to have a material impact on our financial position, results of operations or cash flows. We will continue to monitor additional guidance from the Internal Revenue Service ("IRS").
Our effective tax rate can vary from period to period due to the recognition of discrete events, such as changes in tax reserves, settlements of income tax audits, changes in tax laws and regulations, return-to-provision adjustments, and tax impacts related to stock-based payments, as well as recurring factors, such as changes in our mix of earnings in countries with differing statutory tax rates and our execution of tax planning strategies.
Refer to Note 14, “Taxes Based on Income,” to the Consolidated Financial Statements for more information.
RESULTS OF OPERATIONS BY REPORTABLE SEGMENT
Operating income refers to income before taxes, interest and other non-operating expense (income), net.
Materials Group
| (In millions) | 2022 | 2021 | 2020 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Net sales including intersegment sales | $ | 6,632.2 | $ | 6,312.3 | $ | 5,422.5 | |||||
| Less intersegment sales | (137.1) | (105.8) | (81.9) | ||||||||
| Net sales | $ | 6,495.1 | $ | 6,206.5 | $ | 5,340.6 | |||||
| Operating income(1) | 859.3 | 883.3 | 747.0 | ||||||||
| (1) Included charges associated with restructuring actions and related costs in all years, gain on venture investment in 2022 and 2020, outcomes of legal proceedings and gain on sale of product line in 2021, transaction and related costs and gain on sale of assets in 2021 and 2020 | $ | (13.4) | $ | (25.7) | $ | 30.6 |
Net Sales
The factors impacting reported net sales change are shown in the table below.
| 2022 | 2021 | |||||
|---|---|---|---|---|---|---|
| Reported net sales change | 5 | % | 16 | % | ||
| Foreign currency translation | 6 | (4) | ||||
| Extra week impact | — | 1 | ||||
| Sales change ex. currency(1) | 11 | 13 | ||||
| Acquisitions and product line divestitures | — | (1) | ||||
| Organic sales change(1) | 11 | % | 13 | % |
(1) Totals may not sum due to rounding.
In 2022, net sales increased on an organic basis compared to the same period in the prior year due to pricing actions, partially offset by lower volume/mix. On an organic basis, net sales increased by a mid-to-high single digit rate in emerging markets, a low double-digit rate in North America and a high-teens rate in Western Europe.
In 2021, net sales increased on an organic basis compared to the same period in the prior year due to favorable volume/mix and pricing actions. On an organic basis, net sales increased by a mid-teens rate in emerging markets, a low double-digit rate in North America and a mid-teens rate in Western Europe.
Operating Income
Operating income decreased in 2022 compared to the same period in 2021 primarily due to unfavorable volume/mix, the impact of unfavorable foreign currency translation, higher employee-related costs and the impact of a Brazil indirect tax credit in the prior year, partially offset by the net impact of higher selling prices, higher raw material costs and higher freight costs.
Operating income increased in 2021 compared to 2020 compared to the same period last year primarily due to favorable volume/mix, lower restructuring charges, the Brazil indirect tax credit, favorable foreign currency translation and lower allowance for credit losses. These benefits were partially offset by the net impact of higher sales prices, higher raw material costs, and higher freight costs, as well as higher employee-related costs.
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Solutions Group
| (In millions) | 2022 | 2021 | 2020 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Net sales including intersegment sales | $ | 2,581.6 | $ | 2,239.1 | $ | 1,658.4 | |||||
| Less intersegment sales | (37.4) | (37.3) | (27.5) | ||||||||
| Net sales | $ | 2,544.2 | $ | 2,201.8 | $ | 1,630.9 | |||||
| Operating income(1) | 302.3 | 257.2 | 144.7 | ||||||||
| (1) Included charges associated with restructuring actions and transaction and related costs in all years, outcomes of legal proceedings in 2022 and 2021, net gains on sales of assets in 2022 and 2020, loss on sale of asset and gain on venture investments in 2021 and loss on venture investments in 2020. | $ | 7.8 | $ | 36.6 | $ | 22.7 |
Net Sales
The factors impacting reported net sales change are shown in the table below.
| 2022 | 2021 | |||||
|---|---|---|---|---|---|---|
| Reported net sales change | 16 | % | 35 | % | ||
| Reclassification of sales between segments | (1) | — | ||||
| Foreign currency translation | 4 | (2) | ||||
| Extra week impact | — | 2 | ||||
| Sales change ex. currency(1) | 19 | 35 | ||||
| Acquisitions | (14) | (10) | ||||
| Organic sales change(1) | 5 | % | 25 | % |
(1) Totals may not sum due to rounding.
In 2022, on an organic basis, net sales increased by a mid-teens rate in high value categories and decreased by a low-single digit rate in the base business. Company-wide, on an organic basis, sales of Intelligent Label solutions increased by a mid-teens rate.
In 2021, on an organic basis, net sales in the segment related to Intelligent Labels increased over 20%. Net sales in the base business increased by a low double-digit rate, partially due to the recovery from the prior-period impact of COVID-19.
Operating Income
Operating income increased in 2022 compared to 2021 primarily due to the combined benefit of higher organic volume and acquisitions, the impact of legal proceedings in the prior year, and lower transaction and related costs, partially offset by higher amortization of other intangibles resulting from business acquisitions, growth investments and higher employee-related costs.
Operating income increased in 2021 compared to 2020 primarily due to higher volume, including the impact of acquisitions, benefits from productivity initiatives, including savings from restructuring actions, net of transition costs, and lower restructuring charges, partially offset by higher employee-related costs, the impact of prior-year temporary cost reduction actions, growth investments, outcomes of legal proceedings and higher transaction and related costs.
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FINANCIAL CONDITION
Liquidity
Operating Activities
| (In millions) | 2022 | 2021 | 2020 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Net income | $ | 757.1 | $ | 740.1 | $ | 555.9 | |||||
| Depreciation | 177.4 | 167.3 | 154.2 | ||||||||
| Amortization | 113.3 | 76.8 | 51.1 | ||||||||
| Provision for credit losses and sales returns | 50.1 | 35.7 | 64.0 | ||||||||
| Stock-based compensation | 47.4 | 37.2 | 24.0 | ||||||||
| Pension plan settlements and related charges | — | 1.6 | .5 | ||||||||
| Deferred taxes and other non-cash taxes | 18.4 | 2.6 | 9.3 | ||||||||
| Other non-cash expense and loss (income and gain), net | 23.5 | 10.1 | 44.9 | ||||||||
| Trade accounts receivable | (22.1) | (113.2) | 14.7 | ||||||||
| Inventories | (140.7) | (182.7) | (6.0) | ||||||||
| Accounts payable | 68.2 | 255.2 | (68.2) | ||||||||
| Taxes on income | 18.9 | (7.3) | (35.2) | ||||||||
| Other assets | 15.3 | 4.1 | 18.2 | ||||||||
| Other liabilities | (165.8) | 19.3 | (76.1) | ||||||||
| Net cash provided by operating activities | $ | 961.0 | $ | 1,046.8 | $ | 751.3 |
In 2022, cash flow provided by operating activities decreased compared to 2021 primarily due to changes in operational working capital, higher incentive compensation payments and the timing of payroll payments, partially offset by higher net income and lower income tax payments, net of refunds.
In 2021, cash flow provided by operating activities increased compared to 2020 primarily due to higher net income, changes in operational working capital and lower severance payments related to restructuring actions, partially offset by higher income tax payments, net of refunds.
Investing Activities
| (In millions) | 2022 | 2021 | 2020 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Purchases of property, plant and equipment | $ | (278.1) | $ | (255.0) | $ | (201.4) | |||||
| Purchases of software and other deferred charges | (20.4) | (17.1) | (17.2) | ||||||||
| Proceeds from sales of property, plant and equipment | 2.3 | 1.1 | 9.2 | ||||||||
| Proceeds from insurance and sales (purchases) of investments, net | 1.9 | 3.1 | 5.6 | ||||||||
| Proceeds from sale of product line and venture investment | 1.1 | 7.6 | — | ||||||||
| Payments for acquisitions, net of cash acquired, and venture investments | (39.5) | (1,477.6) | (350.4) | ||||||||
| Net cash used in investing activities | $ | (332.7) | $ | (1,737.9) | $ | (554.2) |
Purchases of Property, Plant and Equipment
In 2022, we invested in buildings and equipment to support growth in certain countries in Asia, including Malaysia, China and Vietnam, and the U.S. for our Solutions Group reportable segment and in the U.S. and certain countries in Europe, primarily in France, and Latin America, primarily in Brazil, for our Materials Group reportable segment. In 2021, we invested in equipment to support growth in the U.S. and certain countries in Asia Pacific, including India and China, and Europe, including France and Luxembourg for our Materials Group reportable segment and in certain countries in Asia Pacific, including China, Malaysia, and Bangladesh, and the U.S. for our Solutions Group reportable segment. In 2020, we invested in equipment and expanded manufacturing facilities to support growth in certain countries in Asia Pacific, including Malaysia, China, Hong Kong, Bangladesh and Vietnam, and the U.S. for our Solutions Group reportable segment and in the U.S. and certain countries in Asia Pacific, including India and China, for our Materials Group reportable segment.
Purchases of Software and Other Deferred Charges
In 2022, 2021 and 2020, we invested in information technology upgrades worldwide.
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Proceeds from Sales of Property, Plant and Equipment
In 2022, the majority of the proceeds from sales of property, plant and equipment was related to the sale of a building in the U.S. and a building and equipment in Europe. In 2021, the majority of the proceeds from sales of property, plant and equipment was related to the sale of equipment in Asia Pacific. In 2020, the majority of the proceeds from sales of property, plant and equipment was related to the sale of a property in Europe.
Proceeds from Insurance and Sales (Purchases) of Investments, Net
In 2022 and 2021, we had lower proceeds from insurance associated with our company-owned life insurance policies.
Proceeds from Sale of Product Line and Venture Investment
In 2022, we received proceeds of $1.1 million from the sale of a venture investment. In 2021, proceeds from the sale of a product line were in our Materials Group reportable segment.
Payments for Acquisitions, Net of Cash Acquired, and Venture Investments
In 2022, we paid purchase consideration, net of cash acquired, of approximately $30 million for the 2022 Acquisitions. We funded the 2022 Acquisitions with cash and commercial paper borrowings. In 2021, we paid purchase consideration, net of cash acquired, of approximately $1.44 billion and $32 million for the Vestcom acquisition and the Other 2021 Acquisitions, respectively. We funded the Vestcom acquisition using the net proceeds from the senior notes we issued in August 2021, commercial paper borrowings and cash. We funded the Other 2021 Acquisitions using cash and commercial paper borrowings. In 2020, we paid consideration, net of cash acquired, of approximately $255 million to acquire Smartrac’s Transponder (RFID Inlay) division (“Smartrac”), which we initially funded through commercial paper borrowings, and approximately $88 million to acquire ACPO, Ltd. We also made certain venture investments in 2022, 2021 and 2020.
Refer to Note 2, “Acquisitions,” to the Consolidated Financial Statements for more information.
Financing Activities
| (In millions) | 2022 | 2021 | 2020 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Net increase (decrease) in borrowings with maturities of three months or less | $ | 34.6 | $ | 259.2 | $ | (110.4) | |||||
| Additional borrowings under revolving credit facility | — | — | 500.0 | ||||||||
| Repayments of borrowings under revolving credit facility | — | — | (500.0) | ||||||||
| Additional long-term borrowings | — | 791.7 | 493.7 | ||||||||
| Repayments of long-term debt and finance leases | (6.3) | (13.4) | (270.2) | ||||||||
| Dividends paid | (238.9) | (220.6) | (196.8) | ||||||||
| Share repurchases | (379.5) | (180.9) | (104.3) | ||||||||
| Net (tax withholding) proceeds related to stock-based compensation | (25.1) | (25.4) | (19.7) | ||||||||
| Other | — | (6.3) | — | ||||||||
| Net cash (used in) provided by financing activities | $ | (615.2) | $ | 604.3 | $ | (207.7) |
Borrowings and Repayment of Debt
During 2022, 2021 and 2020, our commercial paper borrowings were used to fund acquisitions, dividend payments, share repurchases, capital expenditures and other general corporate purposes.
In August 2021, we issued $500 million of senior notes, due February 15, 2032, which bear an interest rate of 2.250%, payable semiannually in arrears. Our net proceeds from this issuance, after deducting underwriting discounts and offering expenses, were $493.7 million. Additionally, in August 2021, we issued $300 million of senior notes, due August 15, 2024, which we can repay without penalty on or after August 15, 2022 and bear an interest rate of 0.850%, payable semiannually in arrears. Our net proceeds from this issuance, after deducting underwriting discounts and offering expenses, were $298 million. We used the net proceeds from these two debt issuances to finance a portion of the Vestcom acquisition.
During 2020, commercial paper borrowings were also used for the Smartrac acquisition, with those borrowings subsequently repaid using a portion of the net proceeds, after deducting underwriting discounts and offering expenses, of $493.7 million from the $500 million of senior notes we issued in March 2020. We used the remaining proceeds from these notes to repay the $250 million aggregate principal amount of senior notes that matured in April 2020. We also repaid $15 million of medium-term notes that matured in June 2020.
In the first quarter of 2020, in light of uncertainty as a result of COVID-19 regarding the availability of commercial paper, which we typically rely upon to fund our day-to-day operational needs, and the relatively favorable terms under our
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$800 million revolving credit facility (the “Revolver”), we borrowed $500 million from the Revolver with a six-month duration. We repaid this amount in June 2020.
Refer to Note 2, “Acquisitions,” and Note 4, “Debt,” to the Consolidated Financial Statements for more information.
Dividends Paid
We paid dividends per share of $2.93, $2.66 and $2.36 in 2022, 2021 and 2020, respectively. In April 2022, we increased our quarterly dividend rate to $.75 per share, representing an increase of approximately 10% from our previous quarterly dividend rate of $.68 per share. In April 2021, we increased our quarterly dividend to $.68 per share, representing an increase of approximately 10% from our previous dividend rate of $.62 per share.
Share Repurchases
From time to time, our Board authorizes the repurchase of shares of our outstanding common stock. Repurchased shares may be reissued under our long-term incentive plan or used for other corporate purposes. In 2022, 2021 and 2020, we repurchased approximately 2.2 million, .9 million and .8 million shares of our common stock, respectively. We temporarily paused share repurchase activity in March 2020 as a result of COVID-19 and resumed repurchases late in the third quarter of 2020.
In April 2022 our Board authorized the repurchase of shares of our common stock with a fair market value of up to $750 million, excluding any fees, commissions or other expenses related to such purchases and in addition to the amount outstanding under our previous Board authorization. Board authorizations remain in effect until shares in the amount authorized thereunder have been repurchased. Shares of our common stock in the aggregate amount of $730.0 million as of December 31, 2022 remained authorized for repurchase under this Board authorization.
Net (Tax Withholding) Proceeds Related to Stock-Based Compensation
In 2022, tax withholding for stock-based compensation was comparable to 2021. In 2021, tax withholding for stock-based compensation increased compared to 2020 primarily as a result of equity awards vesting at higher share prices.
Approximately .02 million and .05 million stock options were exercised in 2021 and 2020, respectively. Refer to Note 12, “Long-Term Incentive Compensation,” to the Consolidated Financial Statements for more information.
Analysis of Selected Balance Sheet Accounts
Long-lived Assets
Property, plant and equipment, net, increased by approximately $63 million to $1.54 billion at year-end 2022, which primarily reflected purchases of property, plant and equipment, partially offset by depreciation expense and the impact of foreign currency translation.
Goodwill decreased by approximately $19 million to $1.86 billion at year-end 2022, which reflected the impact of foreign currency translation, partially offset by the acquired goodwill associated with the 2022 Acquisitions.
Other intangibles resulting from business acquisitions, net, decreased by approximately $71 million to $840 million at year-end 2022, reflecting current year amortization expense and the impact of foreign currency translation, partially offset by the valuation of intangible assets associated with the 2022 Acquisitions.
Refer to Note 3, “Goodwill and Other Intangibles Resulting from Business Acquisitions,” to the Consolidated Financial Statements for more information.
Shareholders’ Equity Accounts
The balance of our shareholders’ equity increased by approximately $108 million to $2.03 billion at year-end 2022. Refer to Note 11, “Supplemental Equity and Comprehensive Income Information,” to the Consolidated Financial Statements for more information.
Impact of Foreign Currency Translation
| (In millions) | 2022 | 2021 | |||||
|---|---|---|---|---|---|---|---|
| Change in net sales | $ | (417) | $ | 201 |
In 2022, international operations generated approximately 72% of our net sales. Our future results are subject to changes in political and economic conditions in the regions in which we operate and the impact of fluctuations in foreign currency exchange and interest rates.
The unfavorable impact of foreign currency translation on net sales in 2022 compared to 2021 was primarily related to euro-denominated sales and sales in China.
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Effect of Foreign Currency Transactions
The impact on net income from transactions denominated in foreign currencies is largely mitigated because the costs of our products are generally denominated in the same currencies in which they are sold. In addition, to reduce our income and cash flow exposure to transactions in foreign currencies, we enter into foreign exchange forward, option and swap contracts where available and appropriate. Refer to Note 5, “Financial Instruments,” to the Consolidated Financial Statements for more information.
Analysis of Selected Financial Ratios
We utilize the financial ratios discussed below to assess our financial condition and operating performance. We believe this information assists our investors in understanding the factors impacting our cash flow other than net income and capital expenditures.
Operational Working Capital Ratio
Operational working capital, as a percentage of annualized current-quarter net sales, is reconciled to working capital (deficit) below. Working capital (deficit) (current assets minus current liabilities) as of the fourth quarter 2022 decreased approximately $205 million compared to the fourth quarter of 2021 primarily due to the reclassification of the $250 million of senior notes due in the second quarter of 2023, partially offset by a decrease in accrued payroll and employee benefits. Our objective is to minimize our investment in operational working capital, as a percentage of annualized current-quarter net sales, to maximize our cash flow and return on investment. Operational working capital, as a percentage of annualized current-quarter net sales, in 2022 was higher compared to 2021. Further information regarding the components of operational working capital is provided below.
| (In millions, except percentages) | 2022 | 2021 | |||||
|---|---|---|---|---|---|---|---|
| (A)Working capital (deficit) | $ | (17.8) | $ | 186.7 | |||
| Reconciling items: | |||||||
| Cash and cash equivalents | (167.2) | (162.7) | |||||
| Other current assets | (230.5) | (240.2) | |||||
| Short-term borrowings and current portion of long-term debt and finance leases | 598.6 | 318.8 | |||||
| Current income taxes payable and other current accrued liabilities | 861.9 | 930.3 | |||||
| (B)Operational working capital | $ | 1,045.0 | $ | 1,032.9 | |||
| (C)Fourth-quarter net sales, annualized | $ | 8,103.6 | $ | 8,732.8 | |||
| Operational working capital, as a percentage of annualized current-quarter net sales (B) ÷ (C) | 12.9 | % | 11.8 | % |
Accounts Receivable Ratio
The average number of days sales outstanding was 62 days in 2022 compared to 59 days in 2021, calculated using the accounts receivable balance at year-end divided by the average daily sales in the fourth quarter of 2022 and 2021, respectively. The increase in average number of days sales outstanding was primarily due to the impact of foreign currency translation, lower volumes due to customer inventory destocking and the timing of collections.
Inventory Ratio
Average inventory turnover was 6.0 in 2022 compared to 7.0 in 2021, calculated using the annualized fourth-quarter cost of products sold in 2022 and 2021, respectively, and divided by the inventory balance at the respective year-end. The decrease in average inventory turnover primarily reflected increased inventory due to lower volumes from customer inventory destocking.
Accounts Payable Ratio
The average number of days payable outstanding was 80 days in 2022 compared to 74 days in 2021, calculated using the accounts payable balance at year-end divided by the annualized fourth-quarter cost of products sold in 2022 and 2021, respectively. The increase in the average number of days payable outstanding from the prior year primarily reflected the impact of higher accounts payable balances due to the timing of payments and the impact of foreign currency translation.
Capital Resources
Capital resources include cash flows from operations, cash and cash equivalents and debt financing, including access to commercial paper borrowings supported by the Revolver. We use these resources to fund our operational needs.
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At year-end 2022, we had cash and cash equivalents of $167.2 million held in accounts at third-party financial institutions. Our cash balances are held in numerous locations throughout the world. At year-end 2022, the majority of our cash and cash equivalents was held by our foreign subsidiaries, primarily in the Asia Pacific region.
To meet our U.S. cash requirements, we have several cost-effective liquidity options available. These options include borrowing funds at reasonable rates, including borrowings from our foreign subsidiaries, and repatriating foreign earnings and profits. However, if we were to repatriate foreign earnings and profits, a portion would be subject to cash payments of withholding taxes imposed by foreign tax authorities. Additional U.S. taxes may also result from the impact of foreign currency fluctuations related to these earnings and profits.
Subsequent to fiscal year 2022, in January 2023, we extended the maturity date of the Revolver by one year to February 13, 2026, and increased the commitments by $400 million, from $800 million to $1.2 billion. Additionally, we amended the Revolver to replace the LIBOR benchmark interest rate with Term SOFR, Euribor and SONIA benchmark interest rates. We use the Revolver as a back-up facility for our commercial paper program and for other corporate purposes.
The Revolver contains a financial covenant that requires us to maintain a maximum leverage ratio (calculated as a ratio of consolidated debt to consolidated EBITDA as defined in the agreement) of not more than 3.50 to 1.00; provided that, in the event of an acquisition by us that exceeds $250 million, which occurred when we acquired Vestcom, the maximum leverage ratio increases to 4.00 to 1.00 for the fiscal quarter in which the acquisition occurs and the three fiscal quarters immediately following that fiscal quarter. As of December 31, 2022 and January 1, 2022, our ratio was substantially below the maximum ratio allowed by the Revolver.
In addition to the Revolver, we have short-term lines of credit available in various countries of approximately $341 million in the aggregate at December 31, 2022. These lines may be cancelled at any time by us or the issuing banks. Short-term borrowings outstanding under these lines of credit were $2.4 million and $11.2 million at December 31, 2022 and January 1, 2022, respectively, with weighted average interest rates of 0.64% and 4.97%, respectively. Refer to Note 4, “Debt,” to the Consolidated Financial Statements for more information.
We are exposed to financial market risk resulting from changes in interest and foreign currency rates, and to possible liquidity and credit risks of our counterparties.
We currently anticipate using cash flows from operations, commercial paper borrowings or other potential debt financing to repay approximately $250 million of senior notes maturing in the second quarter of 2023.
Capital from Debt
The carrying value of our total debt decreased by approximately $3 million to $3.10 billion at year-end 2022 from 2021, primarily reflecting the revaluation of our euro-denominated senior notes, due in March 2025, partially offset by a net increase in commercial paper borrowings.
Credit ratings are a significant factor in our ability to raise short- and long-term financing. The credit ratings assigned to us also impact the interest rates we pay and our access to commercial paper, credit facilities, and other borrowings. A downgrade of our short-term credit ratings could impact our ability to access commercial paper markets. If our access to commercial paper markets were to become limited, as it did in the first quarter of 2020 as a result of COVID-19 when we drew down on the Revolver, the Revolver and our other credit facilities would be available to meet our short-term funding requirements. When determining our credit rating, we believe that rating agencies primarily consider our competitive position, business outlook, consistency of cash flows, debt level and liquidity, geographic footprint and management team. We remain committed to maintaining an investment grade rating.
Fair Value of Debt
The estimated fair value of our long-term debt is primarily based on the credit spread above U.S. Treasury securities or euro government bond securities, as applicable, on notes with similar rates, credit ratings and remaining maturities. The fair value of short-term borrowings, which includes commercial paper issuances and short-term lines of credit, approximates their carrying value given their short duration. The fair value of our total debt was $2.85 billion at December 31, 2022 and $3.25 billion at January 1, 2022. Fair value amounts were determined based primarily on Level 2 inputs, which are inputs other than quoted prices in active markets that are either directly or indirectly observable. Refer to Note 1, “Summary of Significant Accounting Policies,” for more information.
Contractual Obligations, Commitments and Off-Balance Sheet Arrangements
Material Cash Requirements at End of Year 2022
We have short- and long-term material cash requirements related to our contractual obligations that arise in the normal course of business. In addition to principal and interest payments on our outstanding debt obligations, our contractual obligations primarily consist of lease payments and purchase commitments.
Refer to Note 4, "Debt," to the Consolidated Financial Statements for a summary of our principal payments for short-term borrowings and long-term debt obligations as of December 31, 2022. Interest payments for long-term debt as of
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December 31, 2022 were approximately $70 million in 2023; $66 million in 2024; $63 million in 2025; $55 million in 2026; $55 million in 2027; and $150 million from 2028 through maturity.
As of December 31, 2022, we have two commitments to purchase approximately $290 million of raw materials in fiscal year 2023.
Refer to Note 7, "Commitments and Leases," to the Consolidated Financial Statements for a summary of our lease obligations as of December 31, 2022.
Refer to Note 6, “Pension and Other Postretirement Benefits,” to the Consolidated Financial Statements for information regarding our defined benefit pension plan contributions and future benefit payments, deferred compensation plan benefit payments and unfunded termination indemnity benefits.
Refer to Note 12, “Long-term Incentive Compensation,” to the Consolidated Financial Statements for information regarding cash-based awards to employees under our long-term incentive compensation plan.
Refer to Note 14, “Taxes Based on Income,” to the Consolidated Financial Statements for more information regarding our unrecognized tax benefits of approximately $70 million.
CRITICAL ACCOUNTING ESTIMATES
The preparation of financial statements in conformity with GAAP requires our management to make estimates and assumptions for the reporting period and as of the financial statement date. These estimates and assumptions affect our reported amounts of assets and liabilities, disclosure of contingent liabilities and reported amounts of revenue and expense. Actual results could differ from these estimates.
Critical accounting estimates are those that are important to our financial condition and results, and which require us to make difficult, subjective and/or complex judgments. Critical accounting estimates cover accounting matters that are inherently uncertain because their future resolution is unknown. We believe our critical accounting estimates include accounting for goodwill, business combinations, pension and postretirement benefits, taxes based on income and long-term incentive compensation.
Goodwill
Business combinations are accounted for using the acquisition method, with the excess of the acquisition cost over the fair value of net tangible assets and identified intangible assets acquired considered goodwill. As a result, we disclose goodwill separately from other intangible assets. Our reporting units are composed of either a discrete business or an aggregation of businesses with similar economic characteristics.
We perform an annual impairment test of goodwill during the fourth quarter. Certain factors may cause us to perform an impairment test prior to the fourth quarter, including significant underperformance of a business relative to expected operating results, significant adverse economic and industry trends, significant decline in our market capitalization for an extended period of time relative to net book value, or a decision to divest a portion of a reporting unit. In performing impairment tests, we have the option to first assess qualitative factors to determine whether it is necessary to perform a quantitative assessment for goodwill impairment. If the qualitative assessment indicates that it is more-likely-than-not that the fair value of a reporting unit is less than its carrying value, we perform a quantitative assessment.
A quantitative assessment primarily consists of using the present value (discounted cash flow) method to determine the fair value of reporting units with goodwill. We compare the fair value of each reporting unit to its carrying amount, and, to the extent the carrying amount exceeds the unit’s fair value, we recognize an impairment of goodwill for the excess up to the amount of goodwill of that reporting unit. In consultation with outside specialists, we estimate the fair value of our reporting units using various valuation techniques, with the primary technique being a discounted cash flow analysis. A discounted cash flow analysis requires us to make various assumptions about our reporting units, including their respective forecasted sales, operating margins and growth rates, as well as discount rates. Our assumptions about discount rates are based on the weighted average cost of capital for comparable companies. Our assumptions about sales, operating margins and growth rates are based on our forecasts, business plans, economic projections, anticipated future cash flows, and marketplace data. We also make assumptions for varying perpetual growth rates for periods beyond the long-term business plan period. We base our fair value estimates on projected financial information and assumptions that we believe are reasonable. However, actual future results may differ materially from these estimates and projections. The valuation methodology we use to estimate the fair value of reporting units requires inputs and assumptions that reflect current market conditions, as well as the impact of planned business and operational strategies that require management judgment. The estimated fair value could increase or decrease depending on changes in the inputs and assumptions.
In our annual impairment analysis in the fourth quarter of 2022, the goodwill of all reporting units in our Materials Group and Solutions Group reportable segments were tested utilizing a qualitative assessment. Based on this assessment, we determined that the fair values of these reporting units were more-likely-than-not greater than their respective carrying values. Therefore, the goodwill of our reporting units was not impaired.
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Business Combinations
The results of acquired businesses are included in our Consolidated Financial Statements from their acquisition date. Assets and liabilities of an acquired business are recorded at their estimated fair values on the acquisition date. We engage third-party valuation specialists to assist us in determining these fair values where necessary. Any excess consideration over the fair value of assets acquired and liabilities assumed is recognized as goodwill.
The allocation of purchase price requires management to make significant estimates and assumptions. While we believe our assumptions and estimates are reasonable, they are inherently uncertain and based in part on our experience, market conditions, our projections of future performance and information obtained from management of the acquired companies. Critical estimates include, but are not limited to, the following:
•Future revenue and profit margins;
•Royalty rates;
•Discount rates;
•Customer retention rates;
•Technology migration curves; and
•Useful lives assigned to acquired intangible assets.
Acquired identifiable finite-lived intangible assets are amortized on a straight-line basis over their respective estimated useful lives to marketing, general and administrative expense.
Pension and Postretirement Benefits
The assumptions we use in determining projected benefit obligations and the fair value of plan assets for our defined benefit pension plans and other postretirement benefit plans are evaluated by management in consultation with outside actuaries. In the event that we determine that changes are warranted in the assumptions we use, such as the discount rate, expected long-term rate of return or health care costs, future pension and postretirement benefit expenses could increase or decrease. Due to changes in market conditions or participant population, the actuarial assumptions we use may differ from actual results, which could have a significant impact on our pension and postretirement liability and related costs.
Discount Rate
In consultation with our actuaries, we annually review and determine the discount rates we use in valuing our postretirement obligations. The assumed discount rates for our international pension plans reflect market rates for high quality corporate bonds currently available. Our discount rates are determined by evaluating yield curves consisting of large populations of high quality corporate bonds. The projected pension benefit payment streams are then matched with the bond portfolios to determine a rate that reflects the liability duration unique to our pension and postretirement benefit plans. As of December 31, 2022, a .25% increase in the discount rates associated with our international plans would have decreased our year-end projected benefit obligation by $24 million and decreased expected periodic benefit cost for the coming year by approximately $1 million. Conversely, a .25% decrease in the discount rates associated with our international plans would have increased our year-end projected benefit obligation by approximately $24 million and increased expected periodic benefit cost for the coming year by approximately $1 million.
We use the full yield curve approach to estimate the service and interest cost components of net periodic benefit cost for our pension and other postretirement benefit plans. Using this approach, we apply multiple discount rates from a yield curve composed of the rates of return on several hundred high-quality, fixed income corporate bonds available at the measurement date. We believe this approach provides a more precise measurement of service and interest cost by aligning the timing of these plans’ liability cash flows to the corresponding rates on the yield curve.
Long-term Return on Plan Assets
We determine the long-term rate of return assumption for plan assets by reviewing the historical and expected returns of both the equity and fixed income markets, taking into account our asset allocation, the correlation between returns in our asset classes, and our mix of active and passive investments. Additionally, current market conditions, including interest rates, are evaluated and market data is reviewed for reasonableness and appropriateness. An increase or decrease of .25% on the long-term return on assets associated with our international plans would have decreased or increased our periodic benefit cost for the coming year by approximately $2 million.
Taxes Based on Income
Because we are subject to income tax in the U.S. and multiple foreign jurisdictions, judgment is required in evaluating and estimating our worldwide provision, accruals for taxes, deferred taxes and tax positions. Our provision for income taxes is determined using the asset and liability approach in accordance with GAAP. Deferred tax assets represent amounts available to reduce income taxes payable in future years. These assets arise because of temporary differences between the
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financial reporting and tax bases of assets and liabilities, as well as from net operating losses and tax credit carryforwards. These amounts are adjusted, as appropriate, to reflect changes in tax rates expected to be in effect when the temporary differences reverse. We evaluate the realizability of these future tax deductions and credits by assessing the period over which recoverability is allowed by law and the adequacy of future expected taxable income from all sources, including reversal of taxable temporary differences, forecasted operating earnings and available tax planning strategies. Our assessment of these sources of income relies heavily on estimates. Our forecasted earnings by jurisdiction are determined by how we operate our business and any changes to our operations may affect our effective tax rate. For example, our future income tax rate could be adversely affected by earnings being lower than anticipated in jurisdictions in which we have significant deferred tax assets that are dependent on such earnings to be realized. We use our historical experience and operating forecasts to evaluate expected future taxable income. To the extent we do not consider it more-likely-than-not that a deferred tax asset will be recovered, a valuation allowance is established in the period we make that determination.
We calculate our current and deferred tax provision based on estimates and assumptions that could differ from the actual results reflected in income tax returns filed in subsequent years. Adjustments based on filed returns are recorded when identified.
Tax laws and regulations are complex and subject to different interpretations by taxpayers and governmental taxing authorities. We review our tax positions quarterly and adjust the balances if and as new information becomes available. Significant judgment is required in determining our tax expense and evaluating our tax positions, including evaluating uncertainties. Our estimate of the potential outcome of any uncertain tax issue is subject to our assessment of relevant facts and circumstances existing at the balance sheet date, taking into consideration existing laws, regulations and practices of the governmental authorities exercising jurisdiction over our operations. We recognize and measure our uncertain tax positions following the more-likely-than-not threshold for recognition and measurement for tax positions we take or expect to take on a tax return.
Refer to Note 14, “Taxes Based on Income,” to the Consolidated Financial Statements for more information.
Long-Term Incentive Compensation
Valuation of Stock-Based Awards
We base our stock-based compensation expense on the fair value of awards, adjusted for estimated forfeitures, amortized on a straight-line basis over the requisite service period for stock options and restricted stock units (“RSUs”). We base compensation expense for performance units (“PUs”) on the fair value of awards, adjusted for estimated forfeitures, and amortized on a straight-line basis as these awards cliff-vest at the end of the requisite service period. We base compensation expense related to market-leveraged stock units (“MSUs”) on the fair value of awards, adjusted for estimated forfeitures, and amortized on a graded-vesting basis over their respective performance periods.
Compensation expense for awards with a market condition as a performance objective, which includes PUs and MSUs, is not adjusted if the condition is not met, as long as the requisite service period is met.
We determine the fair value of RSUs and the component of PUs that is subject to the achievement of a performance objective based on a financial performance condition based on the fair market value of our common stock as of the date of the grant, adjusted for foregone dividends. Over the performance period of the PUs, the estimated number of shares of our common stock issuable upon vesting is adjusted upward or downward based on the probability of achieving the performance objectives established for the award.
We determine the fair value of stock-based awards that are subject to achievement of performance objectives based on a market condition, which includes MSUs and the other component of PUs, using the Monte-Carlo simulation model, which utilizes multiple input variables, including expected stock price volatility and other assumptions appropriate for determining fair value, to estimate the probability of satisfying the respective target performance objectives established for the award.
Forfeiture Rate
Changes in estimated forfeiture rates are recorded as cumulative adjustments in the period estimates are revised.
Certain of our assumptions are based on management’s estimates, in consultation with outside specialists. Significant changes in assumptions for future awards and actual forfeiture rates could materially impact our stock-based compensation expense and results of operations.
Valuation of Cash-Based Awards
Cash-based awards consist of long-term incentive units (“LTI Units”) granted to eligible employees. LTI Units are classified as liability awards and remeasured at each quarter-end over the applicable vesting or performance period. In addition to LTI Units with terms and conditions that mirror those of RSUs, we also grant certain employees LTI Units with terms and conditions that mirror those of PUs and MSUs.
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RECENT ACCOUNTING REQUIREMENTS
Refer to Note 1, “Summary of Significant Accounting Policies,” to the Consolidated Financial Statements for this information.