STEEL DYNAMICS INC (STLD) FY 2022 MD&A

ITEM 7.        MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-Looking Statements

This report contains some predictive statements about future events, including statements related to conditions in domestic or global economies, conditions in steel, aluminum, and recycled metals market places, Steel Dynamics' revenues, costs of purchased materials, future profitability and earnings, and the operation of new, existing or planned facilities. These statements, which we generally precede or accompany by such typical conditional words as "anticipate", "intend", "believe", "estimate", "plan", "seek", "project", or "expect", or by the words "may", "will", or "should", are intended to be made as "forward-looking", subject to many risks and uncertainties, within the safe harbor protections of the Private Securities Litigation Reform Act of 1995. These statements speak only as of this date and are based upon information and assumptions, which we consider reasonable as of this date, concerning our businesses and the environments in which they operate. Such predictive statements are not guarantees of future performance, and we undertake no duty to update or revise any such statements. Some factors that could cause such forward-looking statements to turn out differently than anticipated include: (1) domestic and global economic factors; (2) global steelmaking overcapacity and imports of steel, together with increased scrap prices; (3) pandemics, epidemics, widespread illness or other health issues, such as COVID-19 or its variants; (4) the cyclical nature of the steel industry and the industries we serve; (5) volatility and major fluctuations in prices and availability of scrap metal, scrap substitutes and supplies, and our potential inability to pass higher costs on to our customers; (6) cost and availability of electricity, natural gas, oil, or other energy resources are subject to volatile market conditions; (7) increased environmental, greenhouse gas emissions and sustainability considerations or regulations; (8) compliance with and changes in environmental and remediation requirements; (9) significant price and other forms of competition from other steel and aluminum producers, scrap processors and alternative materials; (10) availability of an adequate source of supply of scrap for our metals recycling operations; (11) cybersecurity threats and risks to the security of our sensitive data and information technology; (12) the implementation of our growth strategy; (13) litigation and legal compliance; (14) unexpected equipment downtime or shutdowns; (15) governmental agencies may refuse to grant or renew some of our licenses and permits; (16) our senior unsecured credit facility contains, and any future financing agreements may contain, restrictive covenants that may limit our flexibility; and (17) the impacts of impairment charges.

More specifically, we refer you to our more detailed explanation of these and other factors and risks that may cause such predictive statements to turn out differently, as set forth in the sections titled Special Note Regarding Forward-Looking Statements at the beginning of Part I of this Report and Item 1A. Risk Factors, as well as in other subsequent reports we file with the Securities and Exchange Commission. These reports are available publicly on the Securities and Exchange Commission website, www.sec.gov, and on our website, www.steeldynamics.com under “Investors – SEC Filings.”

Operating Statement Classifications

Net Sales. Net sales from our operations are a factor of volumes shipped, product mix and related pricing. We charge premium prices for certain grades of steel, product dimensions, certain smaller volumes, and for value-added processing or coating of our steel products. Except for the steel fabrication operations, we recognize revenues from sales and the allowance for estimated returns and claims from these sales at the point in time control of the product transfers to the customer, upon shipment or delivery. Our steel fabrication operations recognize revenues over time based on completed fabricated tons to date as a percentage of total tons required for each contract.

Costs of Goods Sold. Our costs of goods sold represent all direct and indirect costs associated with the manufacture of our products. The principal elements of these costs are scrap and scrap substitutes (which represent the most significant single component of our consolidated costs of goods sold), steel substrate, direct and indirect labor and related benefits, alloys, zinc, transportation and freight, repairs and maintenance, utilities such as electricity and natural gas, and depreciation.

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Selling, General and Administrative Expenses. Selling, general and administrative expenses consist of all costs associated with our sales, finance and accounting, and administrative departments, including, among other items, labor and related benefits, and professional services.

Companywide profit sharing and amortization of intangible assets are each separately presented in the statement of income.

Interest Expense, net of Capitalized Interest. Interest expense consists of interest associated with our senior credit facilities and other debt, net of interest costs that are required to be capitalized during the construction period of certain capital investment projects

Other (Income) Expense, net. Other income consists of interest income earned on our temporary cash deposits and short-term investments; any other non-operating income activity, including income from investments in unconsolidated affiliates accounted for under the equity method. Other expense consists of any non-operating costs, such as certain acquisition and financing expenses.

2022 Overview

During 2022, domestic steel demand continued to be strong throughout the year, supported most significantly by the construction, automotive, industrial, and energy sectors. Customer steel inventories remained below historical averages for most of the year, allowing for steady order patterns. This strong market environment allowed annual average steel selling prices to remain at historically high levels, with steady steel operations segment metal spreads compared to 2021, partially offset by additional costs of $439 million during start-up at Sinton. Our metals recycling operations experienced a challenging pricing environment in 2022, with ferrous scrap prices generally falling throughout the year. Metal spread compression, coupled with lower volumes, resulted in significantly lower operating income. Our steel fabrication operations segment achieved significantly higher record operating income and record shipments during 2022, on continued strong non-residential construction demand, record average selling prices and stable average steel product pricing. The symbiotic relationship among our three operating segments resulted in record companywide financial and operational performance during 2022.

We achieved record 2022 operational and financial results.

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Consolidated operating income for 2022 increased $790.7 million, or 18%, to $5.1 billion, compared to $4.3 billion in 2021. Net income attributable to Steel Dynamics, Inc. for 2022 increased $648.6 million, or 20%, to $3.9 billion, compared to 2021. Diluted earnings per share attributable to Steel Dynamics, Inc. was $20.92 for 2022, compared to $15.56 for 2021.

Refer to Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part II of our Annual Report on Form 10-K for the year ended December 31, 2021, for additional information regarding results of operations for the year ended December 31, 2021, as compared to the year ended December 31, 2020, and segment operating results for 2021 as compared to 2020.

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Segment Operating Results (dollars in thousands)

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Steel Operations Segment

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Steel operations consist of our electric arc furnace steel mills, producing steel from ferrous scrap and scrap substitutes, utilizing continuous casting, automated rolling mills, numerous value-added downstream steel coating and processing operations, and distribution operations. Our steel operations sell directly to end-users, steel fabricators, and service centers. These products are used in numerous industry sectors, including the construction, automotive, manufacturing, transportation, heavy and agriculture equipment, and pipe and tube (including OCTG) markets. Steel operations accounted for 65% and 72% of our consolidated net sales during 2022 and 2021, respectively. See Item 1. Business for further information on Steel Operations segment operations.

Steel Operations Shipments (tons):

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Segment Results 2022 vs. 2021

During 2022, domestic steel demand remained strong from the construction, automotive, industrial, and energy sectors, resulting in record shipments of 10.8 million tons in 2022, including 828,000 tons from Sinton. Average product pricing for our steel operations, though higher year over year compared to 2021, experienced steady declines throughout 2022 for sheet steel products, which had risen to record levels at the end of 2021. Conversely, long products realized higher selling prices through the majority of 2022. Steel operations segment shipments increased 7% in 2022 compared to 2021, as Sinton started up production throughout the year, with average selling prices remaining steady. Net sales for the steel operations segment were 8% higher in 2022 when compared to 2021, due to stable average steel selling prices and record volumes.

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Metallic raw materials used in our electric arc furnaces represent our single most significant steel manufacturing cost, generally comprising approximately 55% to 65% of our steel mill operations’ manufacturing costs. Our metallic raw material cost consumed in our steel mills increased $28 per net ton, or 6%, in 2022 compared to 2021.

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As a result of scrap costs increasing more than average selling prices, specifically for sheet steel products, metal spread (which we define as the difference between average steel mill selling prices and the cost of ferrous scrap consumed in our steel mills) decreased slightly in 2022 compared to 2021. Due to metal spread compression and additional costs during start-up at Sinton, operating income for the steel operations decreased 29%, to $3.1 billion, in 2022 compared to 2021.

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Metals Recycling Operations Segment

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Metals recycling operations includes both ferrous and nonferrous scrap metal processing, transportation, marketing, brokerage, and scrap management services. In October 2022, we completed our acquisition of ROCA ACERO, S.A. de C.V. (ROCA), whose post-acquisition operations are included in 2022 results. Our steel mills utilize a large portion (approximately 66% in 2022 and 2021) of the ferrous scrap sold by our metals recycling operations as raw material in our steelmaking operations, and the remainder is sold to other consumers, such as other steel manufacturers and foundries. Metals recycling operations accounted for 10% and 12% of our consolidated net sales during 2022 and 2021, respectively.

Metals Recycling Operations Shipments:

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Segment Results 2022 vs. 2021

Our metals recycling operations faced a challenging price environment during 2022. Domestic steel mill utilization rates decreased to approximately 78% in 2022 from 81% in the prior year, impacting demand for ferrous scrap. Net sales for our metals recycling operations decreased 4% in 2022 as compared to 2021, driven by lower shipments and average selling values. Ferrous scrap average selling prices decreased 4% during 2022 compared to 2021, falling nine out of twelve months during the year, while nonferrous average selling prices increased 3%. Ferrous metal spread (which we define as the difference between average selling prices and the cost of purchased scrap) decreased 2%, while nonferrous metal spread also decreased 2% in 2022 compared to 2021. Metals recycling operations operating income in 2022 of $117.3 million decreased $64.7 million, or 36%, from the record in 2021, due to decreased ferrous and nonferrous shipments and metal spread.

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Steel Fabrication Operations Segment

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Steel fabrication operations include seven New Millennium Building Systems joist and deck plants located throughout the United States, and in Northern Mexico. Revenues from these plants are generated from the fabrication of steel joists, girders, trusses, and steel deck used within the non-residential construction industry. Steel fabrication operations accounted for 19% and 10% of our consolidated net sales during 2022 and 2021, respectively.

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Segment Results 2022 vs. 2021

Our steel fabrication operations benefited in 2022 from a steady non-residential construction market, as order activity remained strong throughout the year, resulting in record shipments and significantly higher selling prices. Our order backlog for steel fabrication extends through the first half of 2023. Record net sales for the segment of $4.3 billion increased 141% during 2022, compared to 2021, as shipments increased 8%, and average selling prices increased 123%, or $2,740 per ton.

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The purchase of various steel products is the largest single cost of production for our steel fabrication operations, historically representing approximately two-thirds of the total cost of manufacturing, increasing to approximately three-fourths during 2022 and 2021 consistent with the historically higher steel costs. The average cost of steel consumed increased 24% in 2022, as compared to 2021. Selling prices per ton increased more than steel input costs per ton, resulting in metal spread (which we define as the difference between average selling prices and the cost of purchased steel) increasing 258% in 2022 compared to 2021. This expanded metal spread, coupled with record shipments, resulted in record operating income of $2.4 billion in 2022 compared to $365.3 million in 2021.

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Other Operations

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Consolidated Results 2022 vs. 2021

Selling, General and Administrative Expenses. Selling, general and administrative expenses decreased $98.4 million, or 15%, to $545.6 million during 2022 compared to 2021, representing 2.5% and 3.5% of net sales, respectively. This decrease is due primarily to a $27.7 million decrease in equity-based compensation expense, as well as decreased costs of $64.5 million related to Sinton that were included in selling, general and administrative expenses prior to the completion of the mill’s construction and start-up in early 2022.

Companywide profit sharing expense was $452.6 million in 2022 (including $22.5 million of additional companywide special compensation awarded to all non-executive eligible team members in recognition of the company’s exceptional annual performance), an increase of $64.4 million from the $388.1 million earned during 2021, consistent with increased pretax income. Refer to Note 11. Retirement Plans to the consolidated financial statements elsewhere in this report for further information.

Interest Expense, net of Capitalized Interest. During 2022, interest expense of $91.5 million increased 60% from $57.2 million during 2021. The higher interest expense in 2022 compared to 2021 was due to higher capitalized interest in 2021 ($50.5 million, compared to $15.8 million in 2022) related to the construction of Sinton.

Other (Income) Expense, net.  Net other income was $20.8 million in 2022, compared to net other expense of $34.8 million in 2021. The net other income in 2022 compared to net other expense in 2021 was due primarily to an increase in interest income of $28.0 million associated with our increased invested cash and short-term investment balances, as well as an increase in net earnings from equity investments of $18.6 million.

Income Tax Expense. During 2022, income tax expense of $1.1 billion, at an effective income tax rate of 22.7%, increased 19% from the $962.3 million of income tax expense, at an effective income tax rate of 22.9%, during 2021, consistent with increased pretax earnings. Refer to Note 4. Income Taxes to the consolidated financial statements elsewhere in this report for additional information.

Included in the balance of unrecognized tax benefits at December 31, 2022, are potential benefits of $25.1 million that, if recognized, would affect the effective tax rate. We recognize interest and penalties related to our tax contingencies on a net-of-tax basis in income tax expense. During the year ended December 31, 2022, we recognized expense from the increase of interest expense and penalties of $480,000, net of tax. In addition to the unrecognized tax benefits noted above, we had $1.2 million accrued for the payment of interest and penalties at December 31, 2022.

We file income tax returns in the United States federal jurisdiction as well as income tax returns in various state jurisdictions. The tax years 2019 through 2021 remain open to examination by the Internal Revenue Service and various state and local jurisdictions. At this time, we do not believe there will be any significant examination adjustments that would result in a material change to our financial position, results of operations or cash flows. It is reasonably possible that the amount of unrecognized tax benefits could change in the next twelve months in an amount ranging from zero to $3.3 million, as a result of the expiration of the statute of limitations and other federal and state income tax audits.

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Liquidity and Capital Resources

Capital Resources and Long-term Debt. Our business is capital intensive and requires substantial expenditures for, among other things, the purchase and maintenance of equipment used in our operations, and to remain in compliance with environmental laws. Our short-term and long-term liquidity needs arise primarily from working capital requirements, capital expenditures, including expansion projects, principal and interest payments related to our outstanding indebtedness (no significant principal payments until 2024), dividends to our shareholders, and potential stock repurchases and acquisitions or investments. We have met and intend to continue to meet these liquidity requirements primarily with available cash and cash provided by operations, and long-term borrowings, and we also have availability under our unsecured Revolver. Our liquidity at December 31, 2022, is as follows (in thousands):

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Our total outstanding debt of $3.1 billion at December 31, 2022 is consistent with December 31, 2021. Our total long-term debt to capitalization ratio (representing our long-term debt, including current maturities, divided by the sum of our long-term debt, redeemable noncontrolling interests, and our total stockholders’ equity) was 27.7% and 32.9% at December 31, 2022, and 2021, respectively, decreasing due to the growth in stockholders’ equity from undistributed 2022 earnings.

Our unsecured credit agreement has a senior unsecured revolving credit facility (Facility), which provides a $1.2 billion unsecured Revolver, and matures in December 2024. Subject to certain conditions, we have the opportunity to increase the Facility size by $500.0 million. The unsecured Revolver is available to fund working capital, capital expenditures, and other general corporate purposes. The Facility contains financial covenants and other covenants pertaining to our ability to incur indebtedness and permit liens on certain assets. Our ability to borrow funds within the terms of the unsecured Revolver is dependent upon our continued compliance with the financial and other covenants. At December 31, 2022, we had $1.2 billion of availability on the Revolver, $9.1 million of outstanding letters of credit and other obligations which reduce availability, and there were no borrowings outstanding.

The financial covenants under our Facility state that we must maintain an interest coverage ratio of not less than 2.50:1.00. Our interest coverage ratio is calculated by dividing our last-twelve-months (LTM) consolidated Adjusted EBITDA (earnings before interest, taxes, depreciation, amortization, and certain other non-cash transactions as allowed in the Facility) by our LTM gross interest expense, less amortization of financing fees. In addition, a debt to capitalization ratio of not more than 0.60:1.00 must be maintained. At December 31, 2022, our interest coverage ratio and debt to capitalization ratio were 54.42:1.00 and 0.27:1.00, respectively. We were, therefore, in compliance with these covenants at December 31, 2022, and we anticipate we will continue to be in compliance during the next twelve months.

Working Capital. We generated cash flow from operations of $4.5 billion in 2022 compared to $2.2 billion in 2021. Operational working capital (representing amounts invested in trade receivables and inventories, less current liabilities other than income taxes payable and debt) decreased $112.5 million, or 3%, to $3.2 billion at December 31, 2022, due primarily to decreased inventory values, consistent with decreased steel and scrap selling prices as steel fabrication customer accounts increased with higher selling prices in the fourth quarter of 2022 compared to the same period in 2021.

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Capital Investments. During 2022, we invested $908.9 million in property, plant and equipment, primarily within our steel operations segment, compared with $1.0 billion invested during 2021. Spending at Sinton decreased in 2022 versus 2021 as we completed the construction phase in early 2022. We enter 2023 with ample liquidity of $3.4 billion and anticipated operating cash flow generation to provide for our planned 2023 capital requirements, including the four new flat roll coating lines at Sinton and Heartland. We announced in July our plans to invest $2.5 billion in a new state-of-the-art low-carbon aluminum flat roll mill with two supporting satellite recycled aluminum slab centers, which is planned to be funded by available cash and cash flow from operations. Expenditures began in the third quarter of 2022 and are expected to continue through 2025.

Cash Dividends. As a reflection of continued confidence in our current and future cash flow generation capability and financial position, we increased our quarterly cash dividend by 31% to $0.34 per share in the first quarter of 2022 (from $0.26 per share in 2021), resulting in declared cash dividends of $245.3 million during 2022, compared to $210.9 million during 2021. We paid cash dividends of $237.2 million and $213.0 million during 2022 and 2021, respectively. Our board of directors, along with executive management, approves the payment of dividends on a quarterly basis. The determination to pay cash dividends in the future is at the discretion of our board of directors, after taking into account various factors, including our financial condition, results of operations, outstanding indebtedness, current and anticipated cash needs and growth plans.

Other. Our board of directors has authorized share repurchase programs during prior years, the most recent of which occurred in November 2022 for a program of up to $1.5 billion of the company’s common stock. Under the share repurchase programs, purchases take place as and when we determine in open market or private transactions made based upon the market price of our common stock, the nature of other investment opportunities or growth projects, our cash flows from operations, and general economic conditions. The share repurchase programs do not require us to acquire any specific number of shares, and may be modified, suspended, extended or terminated by us at any time. The share repurchase programs do not have an expiration date. There were $1.8 billion and $1.1 billion of share repurchases during 2022 and 2021, respectively. As of December 31, 2022, we had $1.3 billion remaining available to purchase under the November 2022 share repurchase program. See Part II, Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities for additional information.

Our ability to meet our debt service obligations and reduce our total debt will depend upon our future performance which, in turn, will depend upon general economic, financial, and business conditions, along with competition, legislation and regulatory factors that are largely beyond our control. In addition, we cannot assure that our operating results, cash flows, access to credit markets and capital resources will be sufficient for repayment of our indebtedness in the future. We believe that based upon current levels of operations and anticipated growth, cash flows from operations, together with other available sources of funds, including borrowings under our Revolver, if necessary, will be adequate for the next twelve months for making required payments of principal and interest on our indebtedness, funding working capital requirements, and funding anticipated capital expenditures.

Contractual Obligations and Other Long-Term Liabilities

We have the following minimum commitments under contractual obligations, including purchase obligations, as defined by the Securities and Exchange Commission. A “purchase obligation” is defined as an agreement to purchase goods or services that is enforceable and legally binding and that specifies all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction.

Long-term debt and estimated interest. Refer to Note 3. Long-Term Debt to the consolidated financial statements elsewhere in this report for our long-term debt maturities. Estimated interest payments on our senior unsecured notes were determined based on their outstanding balances through maturity at their contractual interest rates, as detailed in Note 3. Estimated interest payments also include a 0.175% commitment fee on our available Revolver, and an average interest rate of 5.5% on our other debt of $63.7 million. Our estimated interest payments are $102.2 million, $98.3 million, $80.3 million, $75.0 million, $54.6 million, for the years 2023 through 2027, respectively, and $393.2 million thereafter.

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Purchase obligations. We have commitments for the purchase of commodities such as electricity, water, natural gas and its transportation services, fuel, air products, zinc, and electrodes. Refer to Note 9. Commitments and Contingencies to the consolidated financial statements elsewhere in this report for this information.

Construction commitments. We have firm contracts with various vendors for the completion of certain construction projects at our various divisions at December 31, 2022. Refer to Note 9. Commitments and Contingencies to the consolidated financial statements elsewhere in this report for this information.

Lease commitments. We have entered into operating leases relating principally to transportation and other equipment, and some real estate. Refer to Note 12. Leases to the consolidated financial statements elsewhere in this report for this information.

Unrecognized tax benefits. We expect to make cash outlays in the future related to our unrecognized tax benefits; however, due to the uncertainty of the timing, we are unable to make reasonably reliable estimates regarding the period of cash settlement with the respective taxing authorities. Refer to Note 4. Income Taxes to the consolidated financial statements elsewhere in this report for this information.

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Other Matters

Environmental and Other Contingencies

We have incurred, and in the future will continue to incur, capital expenditures and operating expenses for matters relating to environmental control, remediation, monitoring and compliance. During 2022, we incurred costs related to the monitoring and compliance of environmental matters in the amount of approximately $47.7 million and capital expenditures related to environmental compliance of approximately $9.8 million. Of the costs incurred during 2022 for monitoring and compliance, approximately 70% were related to the normal transportation of certain types of waste produced in our steelmaking processes and other facilities, in accordance with legal requirements. We incurred combined environmental remediation costs of approximately $398,000 at all of our facilities during 2022. We have an accrual of $6.2 million recorded for environmental remediation related to our metals recycling operations, and $2.6 million related to our idled Minnesota ironmaking operations. We believe, apart from our dependence on environmental construction and operating permits for our existing and any future manufacturing facilities, that compliance with current environmental laws and regulations is not likely to have a materially adverse effect on our financial condition, results of operations or liquidity. However, environmental laws and regulations evolve and change, and we may become subject to more stringent environmental laws and regulations in the future, such as the impact of United States government or various governmental agencies introducing regulatory changes in response to the potential of climate change.

Critical Accounting Estimates

Management’s Discussion and Analysis of Our Financial Condition and Results of Operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. We review the accounting estimates we use in reporting our financial results on a regular basis. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent liabilities. We evaluate the appropriateness of these estimations and judgments on an ongoing basis. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Results may differ from these estimates due to actual outcomes being different from those on which we based our assumptions. We believe the following critical accounting estimates affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

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Impairments of Long-Lived Tangible and Definite-Lived Intangible Assets. We review long-lived assets for impairment whenever events or changes in circumstances indicate the carrying amount of such assets may not be fully recoverable. Impairment losses are recorded on long-lived assets used in operations when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets’ carrying amounts. The impairment loss is measured by comparing the fair value of the asset to its carrying amount. We consider various factors and determine whether an impairment test is necessary, including by way of examples, a significant and prolonged deterioration in operating results and/or projected cash flows, significant changes in the extent or manner in which an asset is used, technological advances with respect to assets which would potentially render them obsolete, our strategy and capital planning, and the economic environment in markets to be served. When determining future cash flows and if necessary, fair value, we must make judgments as to the expected utilization of assets and estimated future cash flows related to those assets. We consider historical and anticipated future results, general economic and market conditions, the impact of planned business and operational strategies and all other available information at the time the estimates are made. Those estimates and judgments may or may not ultimately prove accurate.

Events occurred during the fourth quarter of 2020, that represented impairment indicators related to the company’s noncore oil and gas joint ventures. Therefore, the company undertook a fourth quarter 2020 assessment of the recoverability of the carrying amounts of these joint ventures’ property, plant and equipment. Based on the joint ventures’ outlook at the time of this 2020 assessment, the company concluded that the carrying amounts of its property, plant and equipment were fully impaired. This assessment resulted in a total non-cash asset impairment charge of $19.4 million, which include amounts attributable to noncontrolling interests of $2.4 million, that in total served to reduce net income attributable to Steel Dynamics, Inc. by $12.0 million for the year ended December 31, 2020.

Goodwill.

Our goodwill, relating to various business combinations, consisted of the following at December 31 (in thousands):

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At least once annually (as of October 1), or when indicators of impairment exist, the company performs an impairment test for goodwill. Goodwill is allocated to various reporting units, which are generally one level below the company’s operating segments. The fair value of the reporting unit is determined by using an estimate of future cash flows utilizing a risk-adjusted discount rate to calculate the net present value of future cash flows (income approach), and for some years by using a market approach based upon an analysis of valuation metrics of comparable peer companies, using Level 3 fair value inputs as provided for under ASC 820. If the fair value exceeds the carrying value of the reporting unit, there is no impairment. If the carrying amount exceeds the fair value, we recognize an impairment loss in the amount by which the carrying value of the net assets assigned to the reporting unit exceeds the fair value of the reporting unit, with the impairment loss not to exceed the amount of goodwill allocated to the reporting unit.

Key assumptions used to determine the estimated fair value of each reporting unit under the discounted cash flows method (income approach) include: (a) expected cash flows for the five-year period following the testing date (including market share, sales volumes and prices, costs to produce and estimated capital needs); (b) an estimated terminal value using a terminal year growth rate determined based on the growth prospects of the reporting unit; and (c) a risk-adjusted discount rate based on management’s best estimate of market participants’ after-tax weighted average cost of capital and market risk premiums. Key assumptions used to determine the estimated fair value of each reporting unit under the market approach include the expected revenues and cash flows in the next year. We consider historical and anticipated future results, general economic and market conditions, the impact of planned business and operational strategies and all available information at the time the fair values of its reporting units are estimated. Those estimates and judgments may or may not ultimately prove accurate.

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Goodwill acquired in past transactions are naturally more susceptible to impairment, primarily due to the fact that they are recorded at fair value based on operating plans and economic conditions at the time of acquisition. Consequently, if operating results and/or economic conditions deteriorate after an acquisition, it could result in the impairment of the acquired asset. A deterioration of economic conditions may not only negatively impact the estimated operating cash flows used in our cash flow models but may also negatively impact other assumptions used in our analyses, including, but not limited to, the estimated cost of capital and/or discount rates. Additionally, we are required to ensure that assumptions used to determine fair value in our analyses are consistent with the assumptions a hypothetical marketplace participant would use. As a result, the cost of capital and/or discount rates used in our analyses may increase or decrease based on market conditions and trends, regardless of whether our actual cost of capital has changed. Therefore, we may recognize an impairment in spite of realizing actual cash flows that are approximately equal to or greater than our previously forecasted amounts. Accordingly, discount rate scenario analysis is performed to evaluate the impact on estimated reporting unit fair values.

Our fourth quarter 2022, 2021, and 2020 annual goodwill impairment analyses did not result in any impairment charges. Management does not believe that it is reasonably likely that our reporting units will fail the goodwill impairment test in the near term, as the determined fair value of the reporting units with goodwill exceeded their carrying value by more than an insignificant amount. Changes in judgments and estimates underlying our analysis of goodwill for possible impairment, including expected future operating cash flows and discount rate, could decrease the estimated fair value of our reporting units in the future and could result in an impairment of goodwill.

Income Taxes. We are required to estimate our income taxes as a part of the process of preparing our consolidated financial statements. This requires us to estimate our actual current tax exposure together with assessing temporary differences resulting from differing treatments of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, we must establish a valuation allowance. We also establish reserves to reduce some or all of the tax benefit of any of our tax positions at the time we determine that the positions become uncertain. We adjust these reserves, including any impact on the related interest and penalties, in light of changing facts and circumstances, such as the progress of a tax audit. A number of years may elapse before a particular matter for which we have established a reserve is audited by a taxing authority and finally resolved. The number of years with open tax audits varies depending on the tax jurisdiction. A tax benefit that has been previously reserved because of a failure to meet the "more likely than not" recognition threshold would be recognized in our income tax expense in the first interim period when the uncertainty disappears. Settlement of any particular issue would usually require the use of cash.

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