Avery Dennison Corp (AVY) FY 2023 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, should be read in conjunction with the Consolidated Financial Statements and related notes thereto, and includes the sections shown below.
| Non-GAAP Financial Measures | 22 |
|---|---|
| Overview and Outlook | 23 |
| Analysis of Results of Operations | 26 |
| Results of Operations by Reportable Segment | 27 |
| Financial Condition | 29 |
| Critical Accounting Estimates | 34 |
| Recent Accounting Requirements | 37 |
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. 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. Based on feedback from investors and financial analysts, we believe that the supplemental non-GAAP financial measures we provide are also useful to their assessments of our performance and operating trends, as well as liquidity. Reconciliations are provided in accordance with Regulation G and S-K and reconcile our non-GAAP financial measures with the most directly comparable GAAP financial measures.
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, currency adjustments due to highly inflationary economies, 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 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, the reclassification of sales between segments; 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 foreign 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.
•Adjusted 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 company-owned life insurance policies, plus proceeds from sales of property, plant and equipment, plus (minus) net proceeds from insurance and sales (purchases) of investments. Where applicable, adjusted free cash flow is also adjusted for certain acquisition-related transaction costs. We believe that adjusted 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
22
Table of Contents
capital as a percentage of annualized current quarter net sales assists investors in assessing our working capital 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 2023, 2022, and 2021 fiscal years consisted of 52-week periods ending December 30, 2023, December 31, 2022 and January 1, 2022, respectively.
Net Sales
The factors impacting reported net sales change, as compared to the prior-year period, are shown in the table below.
| 2023 | 2022 | |||||
|---|---|---|---|---|---|---|
| Reported net sales change | (8) | % | 8 | % | ||
| Foreign currency translation | 1 | 6 | ||||
| Sales change ex. currency(1) | (7) | % | 13 | % | ||
| Acquisitions | (1) | (4) | ||||
| Organic sales change(1) | (8) | % | 10 | % |
(1) Totals may not sum due to rounding.
In 2023, net sales decreased on an organic basis primarily due to lower volume, partially offset by the impact of pricing actions. In 2022, net sales increased on an organic basis primarily due to pricing actions, partially offset by lower volume/mix.
Net Income
Net income decreased from approximately $757 million in 2022 to approximately $503 million in 2023. The major factors affecting this decrease were:
•Lower volume driven primarily by inventory destocking
•Higher restructuring charges
•Increase accrual for a legacy legal matter
•Higher employee-related costs
•Argentine peso remeasurement loss
•Growth investments
Offsetting factors:
•Benefits from productivity initiatives, including temporary cost-saving actions, material re-engineering and savings from restructuring actions, net of transition costs
•The net impact of pricing and raw material input costs
•Lower provision for income taxes
23
Table of Contents
Business Acquisitions
2023 Business Acquisitions
On November 23, 2023, we completed our business acquisition of Silver Crystal Group ("Silver Crystal"), a Canada-based provider of sports apparel customization and application solutions across in-venue, direct-to-business and e-commerce platforms. On May 22, 2023, we completed our business acquisition of LG Group, Inc. ("Lion Brothers"), a Maryland-based designer and manufacturer of apparel brand embellishments. On March 6, 2023, we completed our business acquisition of Thermopatch, Inc. ("Thermopatch"), a New York-based manufacturer specializing in labeling, embellishments and transfers for the sports, industrial laundry, workwear and hospitality industries. These acquisitions expanded the product portfolio in our Solutions Group reportable segment.
The acquisitions of Silver Crystal, Lion Brothers and Thermopatch are referred to collectively as the "2023 Acquisitions."
The aggregate purchase consideration, including purchase consideration payable, for the 2023 Acquisitions was approximately $231 million. We funded the 2023 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 $5 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 final allocations of purchase consideration for the 2023 Acquisitions to assets and liabilities are ongoing as we continue to evaluate certain balances, estimates and assumptions during the measurement period (up to one year from their respective acquisition date). Consistent with the allowable time to complete our assessment, the valuation of certain acquired assets and liabilities, including environmental liabilities and income taxes, is currently pending finalization.
The 2023 Acquisitions were not material, individually or in the aggregate, to the Consolidated Financial Statements.
2022 Business Acquisitions
In January 2022, we completed our business 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 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.
Cost Reduction Actions
2023 Actions
In the third quarter of 2023, we approved a restructuring plan (the "2023 Plan") to further optimize the European footprint of our Materials Group reportable segment by reducing operations in a manufacturing facility in Belgium. The cumulative charges associated with the 2023 Plan consisted of severance and related costs for the reduction of approximately 210 positions as well as asset impairment charges. During 2023 we recorded $30.4 million in restructuring charges related to the 2023 Plan. The activities related to the 2023 Plan are expected to be substantially completed by mid-2025.
We recorded $49.0 million in restructuring charges, net of reversals, related to other 2023 actions (collectively with the 2023 Plan, "2023 Actions"). These charges consisted of severance and related costs for the reduction of approximately 1,450 positions and asset impairment charges at numerous locations across our company.
24
Table of Contents
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 the pandemic. 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 the pandemic. Our activities related to our 2019/2020 actions began in the fourth quarter of fiscal year 2019 and continued through fiscal year 2022.
We realized approximately $69 million and $26 million, respectively, in savings from restructuring, net of transition costs, primarily related to our 2023 actions in 2023 and our 2019/2020 actions in 2022.
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.
Accounting Guidance Updates
Refer to Note 1, “Summary of Significant Accounting Policies,” to the Consolidated Financial Statements for this information.
Cash Flow
| (In millions) | 2023 | 2022 | 2021 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Net cash provided by operating activities | $ | 826.0 | $ | 961.0 | $ | 1,046.8 | |||||
| Purchases of property, plant and equipment | (265.3) | (278.1) | (255.0) | ||||||||
| Purchases of software and other deferred charges | (19.8) | (20.4) | (17.1) | ||||||||
| Proceeds from company-owned life insurance policies | 48.1 | — | — | ||||||||
| Proceeds from sales of property, plant and equipment | 1.0 | 2.3 | 1.1 | ||||||||
| Proceeds from insurance and sales (purchases) of investments, net | 1.9 | 1.9 | 3.1 | ||||||||
| Payments for certain acquisition-related transaction costs | — | .6 | 18.8 | ||||||||
| Adjusted free cash flow | $ | 591.9 | $ | 667.3 | $ | 797.7 |
In 2023, net cash provided by operating activities decreased compared to 2022 primarily due to lower net income and higher tax payments, net of refunds, partially offset by changes in operational working capital and lower incentive compensation payments. In 2023, adjusted free cash flow decreased compared to 2022 primarily due to lower net cash provided by operating activities, partially offset by higher proceeds from company-owned life insurance policies and lower purchases of property, plant and equipment.
Outlook
Certain factors that we believe will contribute to our 2024 results are described below.
•We anticipate net sales to increase due to higher volume as our markets improve following significant inventory destocking downstream from our company in 2023, which we may partially offset with deflation-related pricing actions.
•We anticipate incremental savings from restructuring actions, net of transition costs.
•We expect an insignificant impact to our full-year operating income from foreign currency translation, based on recent rates.
•We expect our full-year effective tax rate to be in the mid-twenty percent range.
25
Table of Contents
ANALYSIS OF RESULTS OF OPERATIONS
Income before Taxes
| (In millions, except percentages) | 2023 | 2022 | 2021 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Net sales | $ | 8,364.3 | $ | 9,039.3 | $ | 8,408.3 | |||||
| Cost of products sold | 6,086.8 | 6,635.1 | 6,095.5 | ||||||||
| Gross profit | 2,277.5 | 2,404.2 | 2,312.8 | ||||||||
| Marketing, general and administrative expense | 1,313.7 | 1,330.8 | 1,248.5 | ||||||||
| Other expense (income), net | 180.9 | (.6) | 5.6 | ||||||||
| Interest expense | 119.0 | 84.1 | 70.2 | ||||||||
| Other non-operating expense (income), net | (30.8) | (9.4) | (4.1) | ||||||||
| Income before taxes | $ | 694.7 | $ | 999.3 | $ | 992.6 | |||||
| Gross profit margin | 27.2 | % | 26.6 | % | 27.5 | % |
Gross Profit Margin
Gross profit margin in 2023 increased compared to 2022 primarily due to benefits from productivity initiatives, including temporary cost-saving actions, material re-engineering and savings from restructuring actions, net of transition costs, and the net impact of pricing and raw material inputs costs, partially offset by lower volume and higher employee-related costs.
Gross profit margin in 2022 decreased compared to 2021 primarily due to 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.
Marketing, General and Administrative Expense
Marketing, general and administrative expense decreased in 2023 compared to 2022 primarily due to benefits from productivity initiatives, including temporary cost-saving actions and savings from restructuring actions, net of transition costs, partially offset by higher employee-related costs and growth investments.
Marketing, general and administrative expense increased in 2022 compared to 2021 primarily due to the impact of acquisitions and growth investments, partially offset by the impact of favorable foreign currency translation.
Other Expense (Income), Net
| (In millions) | 2023 | 2022 | 2021 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Other expense (income), net by type | |||||||||||
| Restructuring charges: | |||||||||||
| Severance and related costs | $ | 70.8 | $ | 7.6 | $ | 10.5 | |||||
| Asset impairment charges and lease cancellation costs | 8.6 | .1 | 3.1 | ||||||||
| Other items: | |||||||||||
| Outcomes of legal proceedings, net | 64.3 | 6.3 | (.4) | ||||||||
| Argentine peso remeasurement loss | 29.9 | — | — | ||||||||
| Transaction and related costs | 5.3 | .3 | 20.9 | ||||||||
| (Gain) loss on venture investments | 1.5 | (13.5) | (23.0) | ||||||||
| (Gain) loss on sales of assets | .5 | (1.4) | .2 | ||||||||
| Gain on sale of product line | — | — | (5.7) | ||||||||
| Other expense (income), net | $ | 180.9 | $ | (.6) | $ | 5.6 |
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 8, "Contingencies," and Note 15, “Segment and Disaggregated Revenue Information,” to the Consolidated Financial Statements for more information regarding outcomes of legal proceedings.
26
Table of Contents
Interest Expense
Interest expense increased by approximately $34.9 million in 2023 compared to 2022, primarily as a result of higher interest rates on borrowings and higher debt levels.
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.
Other Non-Operating Expense (Income), Net
Other non-operating income increased in 2023 compared to 2022 due to higher interest income, primarily in Argentina.
Net Income and Earnings per Share
| (In millions, except percentages and per share amounts) | 2023 | 2022 | 2021 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Income before taxes | $ | 694.7 | $ | 999.3 | $ | 992.6 | |||||
| Provision for income taxes | 191.7 | 242.2 | 248.6 | ||||||||
| Equity method investment (losses) gains | — | — | (3.9) | ||||||||
| Net income | $ | 503.0 | $ | 757.1 | $ | 740.1 | |||||
| Net income per common share | $ | 6.23 | $ | 9.28 | $ | 8.93 | |||||
| Net income per common share, assuming dilution | 6.20 | 9.21 | 8.83 | ||||||||
| Effective tax rate | 27.6 | % | 24.2 | % | 25.0 | % |
Provision for Income Taxes
Our effective tax rate in 2023 increased compared to 2022 primarily due to higher non-deductible expenses resulting from the impact of the Argentine peso remeasurement loss, higher tax charges from the recognition of uncertain tax positions in certain foreign jurisdictions, and lower U.S. federal return-to-provision benefits. Our effective tax rate in 2022 decreased compared to 2021 primarily due to higher benefits related to the settlement of certain foreign tax audits, partially offset by U.S. federal return-to-provision benefits that were lower than in 2021.
Many countries have enacted, or plan to enact, changes to their tax laws based on the Organization for Economic Cooperation and Development ("OECD") Base Erosion and Profit Shifting recommendations to implement a global minimum tax, namely the Pillar Two framework. The first component of the Pillar Two framework is expected to be effective for our company in 2024, with a second component expected to be effective in 2025. While we do not expect the implementation of a global minimum tax to have a material impact on our effective tax rate, our analysis is ongoing as the OECD continues to release additional guidance and countries implement legislation.
Our effective tax rate can vary from period to period due to a variety of factors, such as changes in our mix of earnings in countries with differing statutory tax rates, changes in our tax reserves, settlements of income tax audits, changes in tax laws and regulations, return-to-provision adjustments, tax impacts related to stock-based payments, 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) | 2023 | 2022 | 2021 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Net sales including intersegment sales | $ | 5,968.4 | $ | 6,632.2 | $ | 6,312.3 | |||||
| Less intersegment sales | (157.1) | (137.1) | (105.8) | ||||||||
| Net sales | $ | 5,811.3 | $ | 6,495.1 | $ | 6,206.5 | |||||
| Operating income(1) | 700.9 | 859.3 | 883.3 | ||||||||
| (1) Included charges associated with restructuring actions and related costs in all years, Argentine peso remeasurement loss and loss on sale of assets in 2023, outcomes of legal proceedings in 2023 and 2021, gain on venture investment in 2022, and gain on sale of product line, gain on sale of assets, and transaction and related costs in 2021 | $ | 88.3 | $ | (13.4) | $ | (25.7) |
27
Table of Contents
Net Sales
The factors impacting reported net sales change are shown in the table below.
| 2023 | 2022 | |||||
|---|---|---|---|---|---|---|
| Reported net sales change | (11) | % | 5 | % | ||
| Foreign currency translation | — | 6 | ||||
| Sales change ex. currency(1) | (10) | 11 | ||||
| Organic sales change(1) | (10) | % | 11 | % |
(1) Totals may not sum due to rounding.
In 2023, net sales decreased on an organic basis compared to the same period in the prior year due to lower volume driven primarily by inventory destocking, partially offset by the impact of pricing actions. On an organic basis, net sales decreased by a low double-digit rate in North America, a mid-to-high teens rate in Western Europe and a mid-to-high single digit rate in emerging markets.
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 a low double-digit rate in North America, a high-teens rate in Western Europe and by a mid-to-high single digit rate in emerging markets.
Operating Income
Operating income decreased in 2023 compared to the same period in 2022 primarily due to lower volume, higher restructuring charges and the Argentine peso remeasurement loss, partially offset by benefits from productivity initiatives, including temporary cost-saving actions, material re-engineering and savings from restructuring actions, net of transition costs, and the net impact of pricing and raw material input costs.
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.
Solutions Group
| (In millions) | 2023 | 2022 | 2021 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Net sales including intersegment sales | $ | 2,588.5 | $ | 2,581.6 | $ | 2,239.1 | |||||
| Less intersegment sales | (35.5) | (37.4) | (37.3) | ||||||||
| Net sales | $ | 2,553.0 | $ | 2,544.2 | $ | 2,201.8 | |||||
| Operating income(1) | 165.7 | 302.3 | 257.2 | ||||||||
| (1) Included charges associated with restructuring actions, outcomes of legal proceedings, and transaction and related costs in all years, loss on venture investments in 2023, gain on sales of assets in 2022, loss on sale of asset and gain on venture investments in 2021. | $ | 86.3 | $ | 7.8 | $ | 36.6 |
Net Sales
The factors impacting reported net sales change are shown in the table below.
| 2023 | 2022 | |||||
|---|---|---|---|---|---|---|
| Reported net sales change | — | % | 16 | % | ||
| Reclassification of sales between segments | — | (1) | ||||
| Foreign currency translation | 2 | 4 | ||||
| Sales change ex. currency(1) | 2 | 19 | ||||
| Acquisitions | (3) | (14) | ||||
| Organic sales change(1) | (1) | % | 5 | % |
(1) Totals may not sum due to rounding.
In 2023, on an organic basis, net sales increased by a high single-digit rate in high-value categories and decreased by a low-double digit rate in the base business compared to the prior year. Company-wide, on an organic basis, sales of Intelligent Label solutions increased by a low-double digit rate compared to the prior year.
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 compared to the prior year. Company-wide, on an organic basis, sales of Intelligent Label solutions increased by a mid-teens rate compared to the prior year.
28
Table of Contents
Operating Income
Operating income decreased in 2023 compared to 2022 primarily due to an increased accrual for the Adasa legal matter (described in Note 8, "Contingencies" to the Consolidated Financial Statements), higher employee-related costs, lower volume, growth investments and the impact of unfavorable foreign currency translation, partially offset by benefits from productivity initiatives, including temporary cost-saving actions and savings from restructuring actions, net of transition costs.
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.
FINANCIAL CONDITION
Liquidity
Operating Activities
| (In millions) | 2023 | 2022 | 2021 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Net income | $ | 503.0 | $ | 757.1 | $ | 740.1 | |||||
| Depreciation | 187.4 | 177.4 | 167.3 | ||||||||
| Amortization | 111.0 | 113.3 | 76.8 | ||||||||
| Provision for credit losses and sales returns | 49.9 | 50.1 | 35.7 | ||||||||
| Stock-based compensation | 22.3 | 47.4 | 37.2 | ||||||||
| Deferred taxes and other non-cash taxes | (24.4) | 18.4 | 2.6 | ||||||||
| Other non-cash expense and loss (income and gain), net | 37.1 | 23.5 | 11.7 | ||||||||
| Trade accounts receivable | (16.7) | (22.1) | (113.2) | ||||||||
| Inventories | 111.7 | (140.7) | (182.7) | ||||||||
| Accounts payable | (87.6) | 68.2 | 255.2 | ||||||||
| Taxes on income | (18.7) | 18.9 | (7.3) | ||||||||
| Other assets | 37.7 | 15.3 | 4.1 | ||||||||
| Other liabilities | (86.7) | (165.8) | 19.3 | ||||||||
| Net cash provided by operating activities | $ | 826.0 | $ | 961.0 | $ | 1,046.8 |
In 2023, cash flow provided by operating activities decreased compared to 2022 primarily due to lower net income and higher tax payments, net of refunds, partially offset by changes in operational working capital and lower incentive compensation payments.
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.
Investing Activities
| (In millions) | 2023 | 2022 | 2021 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Purchases of property, plant and equipment | $ | (265.3) | $ | (278.1) | $ | (255.0) | |||||
| Purchases of software and other deferred charges | (19.8) | (20.4) | (17.1) | ||||||||
| Proceeds from company-owned life insurance policies | 48.1 | — | — | ||||||||
| Proceeds from sales of property, plant and equipment | 1.0 | 2.3 | 1.1 | ||||||||
| Proceeds from insurance and sales (purchases) of investments, net | 1.9 | 1.9 | 3.1 | ||||||||
| Proceeds from sale of product line and venture investment | — | 1.1 | 7.6 | ||||||||
| Payments for acquisitions, net of cash acquired, and venture investments | (224.9) | (39.5) | (1,477.6) | ||||||||
| Net cash used in investing activities | $ | (459.0) | $ | (332.7) | $ | (1,737.9) |
29
Table of Contents
Purchases of Property, Plant and Equipment
In 2023, in our Solutions Group reportable segment, we primarily invested in buildings and equipment to support growth in certain countries in Asia Pacific, primarily Malaysia, in the U.S. and in certain countries in Latin America, primarily Mexico; in our Materials Group reportable segment, we primarily invested in buildings and equipment to support growth in the U.S. and in certain countries in Europe, primarily France, and in Asia Pacific, primarily China. In 2022, in our Solutions Group reportable segment, we primarily invested in buildings and equipment to support growth in certain countries in Asia Pacific, including Malaysia, China and Vietnam, and in the U.S.; in our Materials Group reportable segment, we primarily invested in buildings and equipment in the U.S. and certain countries in Europe, primarily France, and Latin America, primarily Brazil. In 2021, in our Materials Group reportable segment, we primarily 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; in our Solutions Group reportable segment we primarily invested in equipment to support growth in certain countries in Asia Pacific, including China, Malaysia and Bangladesh, and in the U.S.
Purchases of Software and Other Deferred Charges
In 2023, 2022 and 2021, we invested in information technology upgrades worldwide.
Proceeds from Company-Owned Life Insurance Policies
In 2023, we utilized approximately $48 million of the cash surrender value available under 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
We paid consideration, net of cash acquired, of approximately $223 million for the 2023 Acquisitions and $30 million for the 2022 Acquisitions. We funded the 2023 Acquisitions and 2022 Acquisitions using cash and commercial paper borrowings. In 2021, we paid consideration, net of cash acquired, of approximately $1.44 billion to acquire CB Velocity Holdings, LLC ("Vestcom") and $32 million to acquire ZippyYum, LLC ("ZippyYum") and JDC Solutions, Inc. ("JDC"). 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 ZippyYum and JDC acquisitions using cash and commercial paper borrowings. We also made certain venture investments in 2023, 2022 and 2021.
Refer to Note 2, “Business Acquisitions,” to the Consolidated Financial Statements for more information.
Financing Activities
| (In millions) | 2023 | 2022 | 2021 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Net increase (decrease) in borrowings with maturities of three months or less | $ | (36.6) | $ | 34.6 | $ | 259.2 | |||||
| Additional long-term borrowings | 394.9 | — | 791.7 | ||||||||
| Repayments of long-term debt and finance leases | (255.9) | (6.3) | (13.4) | ||||||||
| Dividends paid | (256.7) | (238.9) | (220.6) | ||||||||
| Share repurchases | (137.5) | (379.5) | (180.9) | ||||||||
| Net (tax withholding) proceeds related to stock-based compensation | (23.8) | (25.1) | (25.4) | ||||||||
| Other | (1.6) | — | (6.3) | ||||||||
| Net cash (used in) provided by financing activities | $ | (317.2) | $ | (615.2) | $ | 604.3 |
Borrowings and Repayment of Debt
During 2023, 2022 and 2021, our commercial paper borrowings were used to fund acquisitions, dividend payments, share repurchases, capital expenditures and other general corporate purposes.
30
Table of Contents
In March 2023, we issued $400 million of senior notes, due March 15, 2033, which bear an interest rate of 5.750% per year, payable semiannually in arrears. Our net proceeds from this issuance, after deducting underwriting discounts and offering expenses, were $394.9 million, which we used to repay both existing indebtedness under our commercial paper programs and our $250 million aggregate principal amount of senior notes that matured on April 15, 2023.
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.
Refer to Note 2, “Business Acquisitions,” and Note 4, “Debt,” to the Consolidated Financial Statements for more information.
Dividends Paid
We paid dividends per share of $3.18, $2.93 and $2.66 in 2023, 2022 and 2021, respectively. In April 2023, we increased our quarterly dividend rate to $.81 per share, representing an increase of approximately 8% from our previous quarterly dividend rate of $.75 per share. In April 2022, we increased our quarterly dividend to $.75 per share, representing an increase of approximately 10% from our previous dividend rate of $.68 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 2023, 2022 and 2021, we repurchased approximately 0.8 million, 2.2 million and 0.9 million shares of our common stock, respectively.
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 any amount outstanding under our previous Board authorization. Shares of our common stock in the aggregate amount of $592.8 million as of December 30, 2023 remained authorized for repurchase under this Board authorization. Board authorizations remain in effect until shares in the amount authorized thereunder have been repurchased.
Net (Tax Withholding) Proceeds Related to Stock-Based Compensation
In 2023, tax withholding for stock-based compensation was comparable to 2022 and 2021.
Approximately .02 million stock options were exercised in 2021. 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 $86 million to $1.63 billion at year-end 2023, which primarily reflected purchases of property, plant and equipment and the impact of foreign currency translation, partially offset by depreciation expense.
Goodwill increased by approximately $151 million to $2.01 billion at year-end 2023, which reflected the impact of the acquired goodwill associated with the 2023 Acquisitions and foreign currency translation.
Other intangibles resulting from business acquisitions, net, increased by approximately $9 million to $849.1 million at year-end 2023, reflecting the valuation of intangible assets associated with the 2023 Acquisitions, partially offset by current year amortization expense.
Refer to Note 3, “Goodwill and Other Intangibles Resulting from Business Acquisitions,” to the Consolidated Financial Statements for more information.
Other assets decreased by approximately $1 million to $809.6 million at year-end 2023, primarily reflecting the utilization of the cash surrender value available under our company-owned life insurance policies, partially offset by higher operating lease assets.
31
Table of Contents
Long-term Retirement Benefits and Other Liabilities
Other long-term retirement benefits and other liabilities increased by approximately $133 million to $500.3 million at year-end 2023, primarily reflecting the contingent liability recorded for the Adasa legal matter and higher operating lease liabilities.
Shareholders’ Equity Accounts
The balance of our shareholders’ equity increased by approximately $96 million to $2.13 billion at year-end 2023. 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) | 2023 | 2022 | |||||
|---|---|---|---|---|---|---|---|
| Change in net sales | $ | (58) | $ | (417) |
In 2023, international operations generated approximately 69% of our net sales. Our future results are subject to changes in political, social and economic conditions in the regions in which we operate and the impact of fluctuations in foreign currency exchange rates.
The unfavorable impact of foreign currency translation on net sales in 2023 compared to 2022 was primarily related to sales in China, partially offset by favorable impact from euro-denominated sales.
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.
During 2023, the Argentine peso devalued significantly compared to the U.S. dollar which resulted in remeasurement loss of approximately $30 million which was included in "Other expense (income), net" in the Consolidated Statements of Income.
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. 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 2023 was lower than in 2022. Further information regarding the components of operational working capital is provided below.
| (In millions, except percentages) | 2023 | 2022 | |||||
|---|---|---|---|---|---|---|---|
| (A)Working capital (deficit) | $ | 96.5 | $ | (17.8) | |||
| Reconciling items: | |||||||
| Cash and cash equivalents | (215.0) | (167.2) | |||||
| Other current assets | (245.4) | (230.5) | |||||
| Short-term borrowings and current portion of long-term debt and finance leases | 622.2 | 598.6 | |||||
| Current income taxes payable and other current accrued liabilities | 800.2 | 861.9 | |||||
| (B)Operational working capital | $ | 1,058.5 | $ | 1,045.0 | |||
| (C)Fourth-quarter net sales, annualized | $ | 8,442.0 | $ | 8,103.6 | |||
| Operational working capital, as a percentage of annualized current-quarter net sales (B) ÷ (C) | 12.5 | % | 12.9 | % |
32
Table of Contents
Accounts Receivable Ratio
The average number of days sales outstanding was 61 days in 2023 compared to 62 days in 2022, calculated using the accounts receivable balance at year-end divided by the average daily sales in the fourth quarter of 2023 and 2022, respectively.
Inventory Ratio
Average inventory turnover was 6.6 in 2023 compared to 6.0 in 2022, calculated using the annualized fourth-quarter cost of products sold in 2023 and 2022, respectively, and divided by the inventory balance at the respective year-end. The increase in average inventory turnover primarily reflected higher prior-year inventory balances due to customer inventory destocking.
Accounts Payable Ratio
The average number of days payable outstanding was 77 days in 2023 compared to 80 days in 2022, calculated using the accounts payable balance at year-end divided by the annualized fourth-quarter cost of products sold in 2023 and 2022, respectively. The decrease in the average number of days payable outstanding from the prior year primarily reflected the timing of vendor payments, the impact of acquisitions 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.
At year-end 2023, we had cash and cash equivalents of $215.0 million held in accounts at third-party financial institutions in numerous locations throughout the world. At year-end 2023, 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.
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 30, 2023 and December 31, 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 $327 million in the aggregate at December 30, 2023. These lines may be cancelled at any time by us or the issuing banks. Short-term borrowings outstanding under these lines of credit were $1.0 million and $2.4 million at December 30, 2023 and December 31, 2022, respectively, with weighted average interest rates of 2.24% and 0.64%, 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 exchange rates, and to possible liquidity and credit risks of our counterparties.
We currently anticipate using cash flows from operations and commercial paper borrowings to repay the $300 million of senior notes we issued in 2021, which mature in the third quarter of 2024.
Capital from Debt
The carrying value of our total debt increased by approximately $142 million to $3.24 billion at year-end 2023 from 2022, primarily reflecting our issuance of $400 million of senior notes in March 2023 and the revaluation of our euro-denominated senior notes, partially offset by the repayment of our $250 million of senior notes maturing in April 2023 and a net decrease 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 our company 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, the Revolver and our other credit facilities would be available
33
Table of Contents
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 $3.11 billion at December 30, 2023 and $2.85 billion at December 31, 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 2023
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 30, 2023. Future interest payments for long-term debt as of December 30, 2023 are approximately $90 million in 2024; $87 million in 2025; $78 million in 2026; $78 million in 2027; $78 million in 2028; and $199 million from 2029 through maturity.
As of December 30, 2023, we have a commitment to purchase approximately $164 million of raw materials in fiscal year 2024.
Refer to Note 7, "Commitments and Leases," to the Consolidated Financial Statements for a summary of our lease obligations as of December 30, 2023.
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 one of our long-term incentive compensation plans.
Refer to Note 14, “Taxes Based on Income,” to the Consolidated Financial Statements for more information regarding our unrecognized tax benefits of approximately $88 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 our 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.
34
Table of Contents
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 our 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 2023, 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.
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 liabilities 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 non-U.S. 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 30, 2023, a 0.25% increase in the discount rates associated with our non-U.S. plans would have decreased our year-end projected benefit obligation by $27 million and decreased expected periodic benefit cost for the coming year by approximately $1 million. Conversely, a 0.25% decrease in the discount rates associated with our non-U.S. plans would have increased our year-end projected benefit obligation by approximately $27 million and would not have a significant impact on expected periodic benefit cost for the coming year.
35
Table of Contents
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 plan 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 0.25% on the long-term return on assets associated with our non-U.S. 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 for income taxes, 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 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 taxing 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 performance 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.
36
Table of Contents
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 similar to those of PUs and MSUs.
RECENT ACCOUNTING REQUIREMENTS
Refer to Note 1, “Summary of Significant Accounting Policies,” to the Consolidated Financial Statements for this information.