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WABCO HOLDINGS INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) This discussion summarizes the significant factors affecting the results of operations and financial condition of WABCO during the years ended December 31, 2013, 2012 and 2011 and should be read in conjunction with our consolidated financial statements and related notes thereto included elsewhere herein. Certain information in this discussion and analysis regarding industry outlook, our expectations regarding the future performance of our business and other non-historical statements are forward-looking statements. These forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in "Risk Factors" above. Our actual results may differ materially from those contained in any forward-looking statements. You should read the following discussion together with the sections entitled "Risk Factors," "Information Concerning Forward-Looking Statements," "Selected Financial Information," "Liquidity and Capital Resources" and consolidated financial statements and related notes thereto included elsewhere herein. Executive Overview In 2013, global production of trucks and buses greater than six tons increased in most markets, while India experienced a significant decline year over year. We estimate that new truck and bus builds increased by 3% globally. WABCO's sales during full year 2013 increased by 9.8% (9.3% excluding foreign currency translation effects) compared with the same period a year ago. Overall, WABCO continued in 2013 to outperform in the aggregate the global production of trucks and buses. In 2013, WABCO's global aftermarket sales increased by 7.4% (7.1% excluding foreign currency translation effects), compared with the same period a year ago, resulting in record aftermarket revenues on a currency adjusted basis. This performance demonstrates the continued success of the Company's aftermarket strategies initiated several years ago. In 2013, WABCO China was recertified as a high technology enterprise by the government authorities. In 2010, WABCO became one of the first global suppliers in the automotive and commercial vehicle industry to obtain such certification in China, and WABCO remains one of the few in its field with this official status. It also reaffirms WABCO's well-anchored local capabilities and resources in China, the world's largest market for production of trucks and buses. In 2013, WABCO India opened a new factory in Lucknow in the proximity of a major production site for TATA Trucks. WABCO India now has five world-class manufacturing sites located in Ambattur, Chennai; Jamshedpur; Mahindra World City; Pantnagar and Lucknow. WABCO India is also a major hub in WABCO's global manufacturing and sourcing network. It supplies customers based in India, Japan, Europe, and the United States, among other markets internationally. Throughout 2013 and despite variations in volumes of new truck and bus production across markets, WABCO continued to deliver strong profitability. Also during 2013, WABCO's Operating System continued to provide fast and flexible responses to major market changes, delivering $84.2 million of materials and conversion productivity. Gross materials productivity in 2013 represented 5.3% of total materials cost but, as expected, the impact of commodity inflation reduced net materials productivity to 5.0%. Conversion productivity in 2013 represented 6.3%, a new annual record for WABCO. Our Markets and Our Customers Our sales are affected by changes in truck and bus (T&B) production. Europe is our largest geographic market and sales to T&B OEMs represent our largest customer group. The table below shows the relationship between our sales to European T&B OEMs, which account for approximately 57% of our global sales to T&B OEMs, and European T&B production for the last five years. Sales data is shown at a constant Euro to U.S. Dollar exchange rate for year to year comparability and to make comparisons to unit production meaningful. Over the past five years, our sales have outperformed the growth in European T&B production by an average of 4% per year. Year to Year Change 2009 2010 2011 2012 2013 Sales to European T&B OEMs (at a constant FX rate) (58 )% 60 % 34 % (10 )% 13 % European T&B Production (62 )% 52 % 31 % (9 )% 5 % In general, our sales track directionally with truck and bus builds. However, individual year to year sales changes are also influenced by other factors such as timing of orders and deliveries to T&B OEM customers, application content, new 27-------------------------------------------------------------------------------- Table of Contents product introduction, price and introduction of new customer platforms. The level of truck build activity is influenced by general economic conditions, including interest rate levels and inflation. Our aftermarket sales account for approximately 25% of total sales and are affected by a variety of factors: content on specific vehicles and breadth of our product range, number of commercial trucks in active operation, truck age, type of vehicles built, miles driven, demand for transported goods and overall economic activity. On average, our aftermarket sales (on a constant exchange to the U.S. Dollar rate) have grown by 7% annually for the last five years as shown in the table below. Average Year to Year Change 2009 2010 2011 2012 2013 ChangeAftermarket Sales (at constant FX rate) (6 )% 22 % 8 % 5 % 7 % 7 % Distribution of WABCO's Sales by Major End-Markets, Product Types and Geography 2013 2012 2011 Major End-Markets OE Manufacturers: Truck & Bus products 62 % 62 % 64 % Trailer products 9 % 9 % 9 % Car products 4 % 4 % 4 % Aftermarket 25 % 25 % 23 % 100 % 100 % 100 % Geography: Europe 61 % 60 % 62 % North America 11 % 11 % 9 % South America 7 % 6 % 7 % Asia 18 % 20 % 19 % Other 3 % 3 % 3 % 100 % 100 % 100 % Our largest customer is Daimler, which accounts for approximately 12% of our sales. Volvo accounted for 10% of our sales in 2013. Other key customers include Ashok Leyland, BMW, China National Heavy Truck Corporation (CNHTC), Cummins, Fiat (Iveco), Hino, Hyundai, Krone, MAN Nutzfahrzeuge AG (MAN), Meritor, Meritor WABCO (a joint venture), Paccar (DAF Trucks N.V. (DAF), Kenworth, Leyland and Peterbilt), First Automobile Works, Otto Sauer Achsenfabrik (SAF), Scania, Schmitz Cargobull AG, TATA Motors and ZF Friedrichshafen AG (ZF). For the fiscal years ended December 31, 2013 and 2012, our top 10 customers accounted for approximately 52% of our sales each year. Results of Operations Approximately 89% of our sales are outside the United States and therefore, changes in exchange rates can have a significant impact on the reported results of our operations, which are presented in U.S. Dollars. Year-over-year changes in sales, expenses and net income for 2013 compared with 2012 and 2012 compared with 2011, are presented both with and without the effects of foreign currency translation. Changes in sales, expenses and net income excluding foreign exchange effects are calculated using current year sales, expenses and net income translated at prior year exchange rates. Presenting changes in sales, expenses and net income excluding the effects of foreign currency translation is not in conformity with U.S. Generally Accepted Accounting Principles (U.S. GAAP), but we analyze this data because it is useful to us in understanding the operating performance of our business. We believe this data is also useful to shareholders for the same reason. The changes in sales, expenses and net income excluding the effects of foreign exchange translation are not meant to be a substitute for measurements prepared in conformity with U.S. GAAP, nor to be considered in isolation. Management believes that presenting these non-U.S. GAAP financial measures is useful to shareholders because it enhances their understanding of how management assesses the operating performance of the Company's business. 28-------------------------------------------------------------------------------- Table of Contents Results of Operations for 2013 Compared with 2012 Year ended Excluding Foreign December 31, Exchange Translation ** % change 2013 adjusted % change (amounts in millions) 2013 2012 reported amount adjusted Sales $ 2,720.5 $ 2,477.4 9.8 % $ 2,708.8 9.3 % Cost of sales 1,911.4 1,737.2 10.0 % 1,910.8 10.0 % Gross profit 809.1 740.2 9.3 % 798.0 7.8 % Operating expenses 477.2 415.7 14.8 % 469.4 12.9 % Operating income 331.9 324.5 2.3 % 328.6 1.3 % Equity in net income of unconsolidated joint ventures 17.7 18.1 (2.2 )% 17.7 (2.2 )% Other non-operating income/(expense), net 286.4 (5.0 ) * 272.5 * Interest income/(expense), net 4.9 (1.5 ) * 4.7 * Income before income taxes 640.9 336.1 90.7 % 623.5 85.5 % Income tax (benefit)/expense (21.0 ) 23.6 (189.0 )% (13.0 ) (155.1 )% Net income including noncontrolling interests 661.9 312.5 111.8 % 636.5 103.7 % Less: net income attributable to noncontrolling interests 8.7 10.5 (17.1 )% 9.0 (14.3 )% Net income attributable to Company $ 653.2 $ 302.0 116.3 % $ 627.5 107.8 % * Percentage change not considered meaningful ** Amounts translated using 2012 average exchange rates for comparability Sales Our sales for 2013 were $2,720.5 million, an increase of 9.8% (9.3% excluding foreign currency translation effects) from $2,477.4 million in 2012. The increase, excluding foreign currency translation effects, was predominately driven by increased WABCO content per vehicle and a 3% improvement in the global production of new trucks and buses greater than six tons. Total sales in Europe, our largest market, increased approximately 11.3% (8.0% excluding foreign currency translation effects) for the full year 2013, driven mainly by increased WABCO content per vehicle and higher levels of truck, bus and trailer production. Total sales increased 7.8% in North America due to increased WABCO content per vehicle despite reduced commercial vehicle production. Total sales in Asia decreased 1.6% (increased 4.6% excluding foreign currency translation effects). The sales drop in Asia was driven primarily by reductions in total sales in India of 27.8% (21.4% excluding foreign currency translation effects) and in Japan of 13.4% (increase of 5.6% excluding foreign currency translation effects), where the markets experienced significant declines. These decreases were partially offset by an increase in sales in China of 26.5% (23.2% excluding foreign currency translation effects) and South Korea of 6.3% (3.1% excluding foreign currency translation effects). Total sales in South America increased 30.4% (43.2% excluding foreign currency translation effects) driven by increased WABCO content per vehicle in addition to the recovery in production of new trucks and buses in Brazil. The global aftermarket sales performance, included in the geographic numbers provided above, was an increase of 7.4% (7.1% excluding foreign currency translation effects), as we continued to benefit from the Company's aftermarket strategies initiated several years ago. Cost of Sales and Gross Profit Our cost of sales for the year 2013 was $1,911.4 million, an increase of $174.2 million ($173.6 million excluding foreign currency translation effects) from $1,737.2 million in 2012. Within cost of sales, our largest expense is material costs, which mainly represents the purchase of components and parts. Our continued focus on productivity generated 5.3% of material savings before the impact of commodity inflation, which had a negative impact of 0.3%, bringing net materials productivity to 5.0% for the year. This productivity achievement resulted in $58.5 million of material cost savings. Our second largest expense within the cost of sales is for labor and other costs associated with converting our purchased components and parts into finished goods. Labor and other cost escalations increased conversion costs by approximately $14.7 million, while our productivity efforts generated $25.7 million of savings, or 6.3% of the conversion costs. Better claims experience decreased warranty expenses by $9.1 million compared to last year. Streamlining expenses increased costs by $1.6 million. Absorption of overhead costs and other indirect costs were favorable by $45.0 million versus the prior year. Volume and mix increased cost of sales by $251.6 million, and together with the increase in sales contributed $10.9 million to an increase in gross profit. Sales price reductions had a negative impact of $34.2 million on gross profit, or 1.2% of sales. Foreign currency translational effects increased cost of sales by $0.6 million and combined with the translational effects on sales they positively impacted 29-------------------------------------------------------------------------------- Table of Contents gross profit in the amount of $11.1 million. Foreign currency transactional impacts increased cost of sales by $44.0 million and negatively affected gross profit in the amount of $40.9 million. The net result of all these changes was an increase in gross profit of $68.9 million (or $57.8 million excluding foreign currency translation effects). Operating Expenses Operating expenses, which include selling and administrative expenses, product engineering expenses and other operating expenses, increased by $61.5 million ($53.7 million excluding foreign currency translation effects). The increase, excluding foreign currency translation effects, comprised increases in labor and other cost inflation of $11.2 million, incentive compensation of $13.6 million, research and development investments of $13.0 million, pension costs of $4.3 million due to a 2012 reduction in our UK pension obligation and streamlining and separation costs of $6.0 million. In addition, we also saw an increase in investments in global expansion of $5.6 million. Equity in Net Income of Unconsolidated Joint Ventures Equity in net income of unconsolidated joint ventures decreased $0.4 million to $17.7 million in 2013 as compared to $18.1 million in 2012. This decrease was primarily driven by lower income from our South African joint venture, which decreased by $0.9 million. Other Non-Operating Income, net In 2013 we received a reimbursement of $279.5 million on a fine previously assessed in 2010 by the European Commission (EC) as further discussed in Note 14 of Notes to the Consolidated Financial Statements. Excluding this gain in 2013, non-operating income amounted to $6.9 million versus an expense of $5.0 million for 2012, primarily a result of the release of an accrual for tax indemnification liabilities due to the settlement of a foreign tax audit. Interest Expense, net Net interest income increased by $6.4 million to $4.9 million in 2013 compared to an expense of $1.5 million in 2012. This was mainly a result of interest income received on the EC fine reimbursement amounting to €4.0 million or approximately $5.4 million. Income Taxes The income tax benefit for 2013 was $21.0 million on $640.9 million of pre-tax income before adjusting for noncontrolling interest, compared with an income tax provision of $23.6 million on pre-tax income of $336.1 million before adjusting for noncontrolling interest in 2012. The income tax benefit for 2013 includes taxes on earnings in profitable jurisdictions, income offset by fully valued net operating losses, the accrual of interest on uncertain tax positions, and a tax provision on unremitted foreign earnings of $300.0 million in a Belgian affiliate for which the Company does not assert permanent reinvestment outside the United States. This assertion is resulting from the Company recognizing earnings in the fourth quarter of 2013 from the receipt of an exceptional refund including interest from the European Commission related to the Company's appeal of the EC fine as further discussed in Note 15 of Notes to the Consolidated Financial Statements. Additionally, the Company recorded a tax benefit of $178.4 million for a release at the end of the year of a valuation allowance related to management's determination that it is more likely than not that the Company will realize its deferred tax asset in a foreign jurisdiction. In particular, evidence such as our historical operating profits resulting in a cumulative profitable position during the three-year period ending on December 31, 2013, the receipt of an exceptional EC fine refund in the fourth quarter of 2013 and projected operating profits represented sufficient positive evidence to release a full valuation allowance at the end of 2013 on the deferred tax asset under ASC 740. This release was recorded as an income tax benefit as of December 31, 2013 which significantly reduced the effective tax rate, resulting in a negative effective tax rate. We expect our effective tax rate to increase in subsequent periods following this release of the valuation allowance. Our net income and effective tax rate will be negatively affected in periods following this release. However, the valuation allowance release will not affect the amount of cash paid for income taxes. Management has also determined that it is more likely than not that it will not realize $10.1 million of its deferred tax assets in other foreign jurisdictions since evidence such as historical operating profits resulted in a cumulative loss position during the most recent three-year period ending on December 31, 2013 and lack of projected earnings provided sufficient negative evidence to record a valuation allowance against such deferred tax assets. 30-------------------------------------------------------------------------------- Table of Contents Furthermore, in the first quarter of 2013, the Company recognized a tax benefit of $2.4 million due to the impact of U.S. tax legislation enacted in January 2013 and a tax benefit of $2.4 million related to the Company's filing of its 2012 U.S. Federal Income Tax Return in September 2013 that was recorded during the third quarter. Net Income Attributable to Noncontrolling Interests Net income attributable to noncontrolling interests decreased by $1.8 million ($1.5 million excluding foreign currency translation effects) to $8.7 million in 2013, primarily the result of a decrease in earnings from WABCO India. Backlog Backlog, which represents valid sales orders that have not yet been filled as of the end of the reporting period, was $1.3 billion at the end of 2013, an increase of 19.6% (18.1% excluding foreign currency translation effects) from the end of 2012. Backlog is not necessarily predictive of future business as it relates only to some of our products, and customers may still change future delivery dates. 31-------------------------------------------------------------------------------- Table of Contents Results of Operations for 2012 Compared with 2011 Year ended Excluding Foreign December 31, Exchange Translation ** % change 2012 adjusted % change (amounts in millions) 2012 2011 reported amount adjusted Sales $ 2,477.4 $ 2,794.1 (11.3 )% $ 2,659.6 (4.8 )% Cost of sales 1,737.2 1,986.1 (12.5 )% 1,862.8 (6.2 )% Gross profit 740.2 808.0 (8.4 )% 796.8 (1.4 )% Operating expenses 415.7 438.1 (5.1 )% 444.5 1.5 % Operating income 324.5 369.9 (12.3 )% 352.3 (4.8 )% Equity in net income of unconsolidated joint ventures 18.1 16.5 9.7 % 18.3 10.9 % Other non-operating (expense)/income, net (5.0 ) 20.2 (124.8 )% (5.3 ) (126.2 )% Interest expense, net (1.5 ) (1.7 ) (11.8 )% (1.5 ) (11.8 )% Income before income taxes 336.1 404.9 (17.0 )% 363.8 (10.2 )% Income tax expense 23.6 36.7 (35.7 )% 27.0 (26.4 )% Net income including noncontrolling interests 312.5 368.2 (15.1 )% 336.8 (8.5 )% Less: net income attributable to noncontrolling interests 10.5 11.2 (6.3 )% 11.5 2.7 % Net income attributable to Company $ 302.0 $ 357.0 (15.4 )% $ 325.3 (8.9 )% ** Amounts translated using 2011 average exchange rates for comparability Sales Our sales for 2012 were $2,477.4 million, a decrease of 11.3% (4.8% excluding foreign currency translation effects) from $2,794.1 million in 2011. The decrease, excluding foreign currency translation effects, was predominately driven by a 10.2% decline in the global production of new trucks and buses greater than six tons. Total sales in Europe, our largest market, decreased approximately 13.9% (7.0% excluding foreign currency translation effects) for the full year 2012, driven mainly by lower levels of truck, bus and trailer production. Total sales increased 11.7% in North America, which benefited from increased commercial vehicle production. Total sales in Asia decreased 8.1% (4.4% excluding foreign currency translation effects). The sales drop in Asia included reduction in total sales in: India of 19.1% (7.8% excluding foreign currency translation effects), South Korea of 17.1% (14.7% excluding foreign currency translation effects), China of 6% (8.5% excluding foreign currency translation effects) and an increase in total sales in Japan of 11% (11.8% excluding foreign currency translation effects). Total sales in South America decreased 28.1% (15.9% excluding foreign currency translation effects) driven by the anticipated decline in production of new trucks and buses in Brazil resulting from higher levels of production in 2011 ahead of the emission mandate as well as the termination of the government sponsored incentive program at the end of 2011. Based on our analysis, WABCO's sales growth for 2012 continued to outperform the aggregate global market. The global aftermarket sales decrease, included in the geographic numbers provided above, was 2.5% (increase of 5.2% excluding foreign currency translation effects). This performance, excluding foreign currency translation effects, demonstrates the continued success of the Company's aftermarket strategies initiated several years ago. Cost of Sales and Gross Profit Our cost of sales for the year 2012 was $1,737.2 million, a decrease of $248.9 million ($123.3 million excluding foreign currency translation effects) from $1,986.1 million in 2011. Within cost of sales, our largest expense is material costs, which mainly represents the purchase of components and parts. Our continued focus on productivity generated 5.3% of material savings before the impact of commodity inflation, which had a negative impact of 0.9%, bringing net materials productivity to 4.4% for the year. This productivity achievement resulted in $43.0 million of material cost savings. Our second largest expense within the cost of sales is for labor and other costs associated with converting our purchased components and parts into finished goods. Labor and other cost escalations increased conversion costs by approximately $16.8 million, while our productivity efforts generated $23.6 million of savings, or 6.1% of the conversion costs. Better claims experience decreased warranty expenses by $10.4 million compared to last year. Absorption of overhead costs and other indirect costs were unfavorable by $37.3 million versus the prior year. Volume and mix decreased cost of sales by $78.6 million, and together with the decrease in sales contributed $31.9 million to decrease of gross profit. Sales price reductions had a negative impact of $16.9 million on gross profit, or 0.6% of sales. Foreign currency translational effects decreased cost of sales by $125.7 million, but combined with translational effects on sales they negatively affected gross profit in the amount of $56.6 million. Foreign currency transactional impacts decreased cost of sales by $21.8 million and positively affected gross profit in the 32-------------------------------------------------------------------------------- Table of Contents amount of $14.7 million. The net result of all these changes was a decrease in gross profit of $67.8 million ($11.2 million excluding foreign currency translation effects). Operating Expenses Operating expenses, which include selling and administrative expenses, product engineering expenses and other operating expenses, decreased by $22.4 million (increased by $6.4 million excluding foreign currency translation effects). The increase excluding foreign currency translation effects comprises increases in labor and other cost inflation of $10.5 million, research and development investments of $7.8 million and streamlining and separation expenses of $9.2 million. These increases are partially offset by reduction in incentive compensation of $16.1 million, reduction in our UK pension obligation of $4.3 million and other net savings of $0.7 million. Equity in Net Income of Unconsolidated Joint Ventures Equity in net income of unconsolidated joint ventures increased $1.6 million to $18.1 million in 2012 as compared to $16.5 million in 2011. The increase was primarily driven by income from the Meritor WABCO joint venture, which increased by $1.7 million. Other Non-Operating Expense, net Non-operating income amounted to $20.2 million in 2011. This amount was primarily made up of the reversal of approximately $23.1 million of indemnification liabilities due to the closing of a tax audit and other settlements. Absent this income our other non-operating result, net was an expense of $5.0 million in 2012. The primary component of the 2012 expense was driven by the accrual of a tax indemnification liability of $3.4 million. Interest Expense, net Net interest expense decreased by $0.2 million to $1.5 million of expense in 2012 compared to $1.7 million of expense in 2011. Income Taxes The income tax provision for 2012 was $23.6 million on $336.1 million of pre-tax income before adjusting for noncontrolling interest, compared with $36.7 million on a pre-tax income of $404.9 million before adjusting for noncontrolling interest in 2011. The tax provision for 2012 includes taxes on earnings in profitable jurisdictions, income offset by fully valued net operating losses, the accrual of interest on uncertain tax positions, and certain foreign tax planning. Additionally, the income tax provision is offset by the release of tax accruals for uncertain tax positions due to certain government filings submitted in January 2012 of approximately $24.8 million, as adjusted from an amount of $18.8 million as previously disclosed in the Company's 2011 Form 10-K. Furthermore, a tax benefit of $4.1 million related to the Company's filing of its 2011 U.S. Federal Income Tax Return in September 2012 was recorded during the third quarter. Net Income Attributable to Noncontrolling Interests Net income attributable to noncontrolling interests decreased by $0.7 million (increased by $0.3 million excluding foreign currency translation effects) to $1.8 million in 2012. The decline is primarily the result of a decrease in earnings from WABCO India, partially offset by improved results of WABCO Compressor Manufacturing. Backlog Backlog, which represents valid sales orders that have not yet been filled as of the end of the reporting period, was $1.1 billion at the end of 2012, down 2.9% (0.5% excluding foreign currency translation effects) from the end of 2011. Backlog is not necessarily predictive of future business as it relates only to some of our products, and customers may still change future delivery dates. 33-------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources We employ several means to manage our liquidity, and we are not dependent upon any one source of funding. Our sources of financing include cash flows from operations, cash and cash equivalents, our revolving credit facility, our Accounts Receivable Securitization Program and the use of operating leases. We believe the combination of expected cash flows, the revolving credit facility being committed until September 2018, and the Accounts Receivable Securitization Program maturing in September 2016 (subject to annual renewal) will provide us with adequate liquidity to support the Company's operations. The Company also has the ability to access a wide range of additional external financing instruments. Specifically for 2014 we expect an increase in our capital spending primarily due to the construction of a new plant in Poland. Outside of our capital expenditures, our overall cash flow is expected to be in line with the Company's 2013 cash flow profile, and there are no known trends or uncertainties that are reasonably expected to have a material effect on the separate sources and uses of cash. As of December 31, 2013, $461.3 million of the $472.8 million of cash and cash equivalents on the consolidated balance sheet was held by foreign subsidiaries, confirming our focus and intent to use our cash outside the United States. The Company considers the earnings of substantially all of its foreign subsidiaries to be permanently reinvested outside the United States and as such no additional U.S. tax cost has been provided. The Company has provided for tax at the U.S. tax rate for its Brazilian affiliate's current year earnings in 2013. In addition, a tax provision was also provided on unremitted foreign earnings of $300.0 million in a Belgian affiliate for which the Company does not assert permanent reinvestment outside the United States. This assertion is resulting from the Company recognizing earnings in the fourth quarter of 2013 from the receipt of an exceptional refund including interest from the European Commission related to the Company's appeal of the EC fine as further discussed in Note 15 of Notes to the Consolidated Financial Statements. The Company estimates the amount of its unremitted foreign earnings permanently reinvested outside the United States to be approximately $840 million as of December 31, 2013; however, it is not practicable to estimate the tax liability that would arise if the earnings that are considered permanently reinvested were remitted to the United States. Cash Flows for 2013 Compared with 2012 Net cash provided by operating activities was $665.8 million for 2013 compared with net cash provided by operating activities of $358.3 million for 2012. We recorded net income including noncontrolling interests of $661.9 million for 2013 compared with net income including noncontrolling interests of $312.5 million for 2012. Net income for 2013 included $279.5 million related to the EC fine reimbursement, as well as noncash elements such as depreciation and amortization of $85.2 million. Our working capital increased by $27.2 million, primarily driven by higher accounts receivable and to a lesser extent inventory. The decrease of receivables in the fourth quarter, mainly due to significant collections at year-end, was not sufficient to offset the increase in the first three quarters, a result of an increase in business activity. This also resulted in a higher level of payables which only partially offset the above. The change in other accrued liabilities and taxes was an increase of $38.5 million for 2013 compared to a decrease of $37.9 million for 2012. The major drivers of this change were increases in accruals for payroll and incentive compensation, as well as accruals for uninvoiced goods and services. The change in other current and long-term assets for 2013 was an increase of $28.8 million compared to a decrease of $23.0 million for 2012. The main drivers of this change were increases in tax related items, notes receivables from our Chinese operations and restricted cash related to the Accounts Receivable Securitization Program. The change in other long-term liabilities for 2013 was a decrease of $9.8 million compared to an increase of $2.1 million for 2012, mainly a result of the payment and release of the remaining accrual for tax indemnification liabilities due to the settlement of a foreign tax audit. The net cash used in investing activities amounted to $176.7 million in 2013 compared to net cash used in investing activities of $105.6 million in 2012. The net cash usage for 2013 includes capital expenditures of $47.0 million of investments in tooling, $61.1 million on plant and equipment and $13.4 million in computer software, which supported our market growth and new programs during the year. This compared with $43.2 million of investments in tooling, $48.5 million on plant and equipment and $8.8 million in computer software in 2012, as well as $5.1 million for acquisitions. We also purchased $55.2 million of short-term investments in 2013. The net cash used by financing activities during 2013 amounted to $193.4 million compared to net cash used by financing activities of $182.6 million during 2012. 34-------------------------------------------------------------------------------- Table of Contents As of December 31, 2013, our total third party debt was $87.1 million, consisting primarily of $47.0 million of long-term debt borrowed under our $400 million five-year revolving credit facility. During 2013, we had net borrowings of approximately $1.1 million on our revolving credit facility. Also, subsidiaries in other countries had borrowings from banks totaling $40.1 million classified as short-term debt. The increase in net borrowings of short-term debt from the prior year of $9.2 million is driven by a $36.4 million loan under a short-term borrowing with Société Générale Bank Nederland N.V. related to the Accounts Receivable Securitization Program. We received $49.7 million of stock option proceeds during 2013 compared with $28.6 million in 2012. The number of stock options exercised in 2013 and 2012 were 1,602,068 and 1,312,288, respectively. We also paid $4.6 million during 2013 for the acquisition of the remaining shares in SWAP, our Chinese joint venture. During 2013, we also paid $243.2 million for share repurchases. As of December 31, 2013, we had the authority to make an additional $379.7 million of share repurchases. Between January 1, 2014 and February 13, 2014, we have repurchased an additional 93,164 shares for a total of $8.5 million. Cash Flows for 2012 Compared with 2011 Net cash provided by operating activities was $358.3 million for 2012 compared with net cash provided by operating activities of $332.0 million for 2011. We recorded net income including noncontrolling interests of $312.5 million for 2012 compared with net income including noncontrolling interests of $368.2 million for 2011. Net income for 2012 included noncash elements such as depreciation and amortization of $76.9 million. Our working capital increase was primarily driven by a reduction in accounts payable due to timing of payments at year end. Inventory levels decreased with business activity, while accounts receivable increased, partially due to late payments from customers. Although we had a positive impact from working capital in the second half of the year, this could not offset entirely the increase of the first half of the year. The change in other accrued liabilities and taxes was a decrease of $37.9 million for 2012 compared to a decrease of $4.4 million for 2011. The major drivers of this change were tax related items, change in incentive compensation accruals, decreases in freight accruals as well as in short term portion of warranty accruals. The change in other current and long-term assets for 2012 was a decrease of $23.0 million compared to an increase of $34.8 million for 2011. The main drivers of this change were decreases in tax related items and restricted cash related to the Accounts Receivable Securitization Program. The change in other long-term liabilities for 2012 was an increase of $2.1 million compared to an increase of $8.6 million for 2011. The main drivers were increases in a long term portion of warranty accrual partially offset by a decrease in long term tax related items which included the release of accruals for uncertain tax positions due to certain government filings in January 2012 as previously disclosed in the Company's 2011 Form 10-K. The net cash used in investing activities amounted to $105.6 million in 2012 compared to net cash used in investing activities of $105.2 million in 2011. The net cash usage for 2012 includes capital expenditures of $43.2 million of investments in tooling, $48.5 million on plant and equipment and $8.8 million in computer software, which supported our market growth and new programs in 2012. Additionally we spent $5.1 million for acquisitions. This compared with $40.1 million of investments in tooling, $58.2 million on plant and equipment and $6.9 million in computer software in 2011. The net cash used by financing activities during 2012 amounted to $182.6 million compared to net cash used by financing activities of $183.5 million during 2011. As of December 31, 2012, our total third party debt was $76.2 million consisting primarily of $46.3 million of short-term debt borrowed under our $400 million five-year revolving credit facility. During 2012, we repaid approximately $11.6 million of debt outstanding at December 31, 2011 on our revolving credit facility. Also, subsidiaries in other countries had borrowings from banks totaling $29.5 million classified as short-term debt. The increase in net borrowings of short-term debt from the prior year of $3.6 million is driven by a $27.7 million under a short-term borrowing with Société Générale Bank Nederland N.V. related to the Accounts Receivable Securitization Program. We received $28.6 million of stock option proceeds during 2012 compared with $36.6 million in 2011. The number of stock options exercised in 2012 and 2011 were 1,312,288 and 1,630,838, respectively. During 2012, we repurchased shares in the amount of $198.9 million, of which $2.5 million was not settled until after December 31, 2012. 35-------------------------------------------------------------------------------- Table of Contents Credit Facility On July 8, 2011, we entered into a $400 million multi-currency five-year senior unsecured revolving credit facility with the lenders and agent banks party thereto, including Banc of America Securities Limited as agent, issuing bank and swingline lender, and Banc of America Securities Limited, Citigroup Global Markets Limited, Fortis Bank S.A./N.V., ING Belgium SA/NV, Société Générale Corporate & Investment Banking, The Bank of Tokyo-Mitsubishi UFJ, Ltd and The Royal Bank of Scotland NV, (Belgium) Branch, as mandated lead arrangers and bookrunners and Credit Lyonnais and Unicredit Bank AG as lead arrangers. As of December 31, 2013, this is our principal bank credit facility, and it expires on September 1, 2018. The original expiry date of September 1, 2016 was extended in August 2013 to the current expiry date. Under the revolving credit facility, we may borrow, on a revolving basis, loans in an aggregate principal amount at any one time outstanding not in excess of $400 million. Up to $50 million under this facility may be used for issuing letters of credit, of which $48.8 million was unused as of December 31, 2013, and up to $50 million is available in the form of swingline loans, all $50.0 million of which was available for use as of December 31, 2013. As of December 31, 2013 and 2012, the carrying amount of this facility approximated fair value based on Level 2 inputs. The balance outstanding on this facility as of December 31, 2013, was $47.0 million in addition to $1.2 million of letters of credit, compared to $46.3 million and $1.3 million, respectively, as of December 31, 2012. The aggregate interest rates applicable on loan drawings as of December 31, 2013 and 2012 were 1.04% and 0.93%, respectively. The proceeds of the borrowings under the revolving credit facility may be used to repurchase WABCO shares, finance acquisitions, refinance existing indebtedness and meet general financing requirements. Interest on loans under the revolving credit facility is calculated at a rate per annum equal to an applicable margin which can vary from 0.80% to 1.55% based on the Company's leverage ratio plus LIBOR for loans denominated in U.S. Dollars, EURIBOR for loans denominated in Euros, HIBOR for loans denominated in Hong Kong Dollars and SIBOR for loans denominated in Singapore Dollars, plus mandatory costs, if any. The applicable margins used to determine the LIBOR loan rate are determined based upon the Company's leverage ratio, which represents the ratio of our consolidated net indebtedness on the last day of any fiscal quarter to consolidated adjusted EBITDA (earnings before interest, taxes, depreciation and amortization adjusted for certain items) for the period of four consecutive fiscal quarters ending on such day. The revolving credit facility also provides for certain of the borrowers to pay various fees including a participation fee on the amount of the lenders' commitments thereunder. The revolving credit facility contains terms and provisions (including representations, covenants and conditions) customary for credit agreements of this type. Our primary financial covenant is a leverage test which requires net indebtedness not to exceed three times adjusted four quarter trailing EBITDA. Additional financial covenants include an interest coverage test and a maximum subsidiary indebtedness test. The interest coverage test requires three times interest expense not to exceed adjusted four quarter trailing EBITDA. The maximum subsidiary indebtedness test limits the total aggregate amount of indebtedness of WABCO's subsidiaries, excluding indebtedness under the revolving credit facility, to $400 million, of which not more than $150 million may be secured. Financial covenants are not subject to any future changes in U.S. GAAP accounting standards and all cash on the balance sheet can be deducted for net indebtedness purposes. In addition, expenses and payments related to any streamlining of WABCO's operations are excluded when calculating the four quarter trailing adjusted EBITDA. Other covenants include delivery of financial reports and other information, compliance with laws including environmental laws and permits, ERISA and U.S. regulations, limitations on liens, mergers and sales of assets and change of business. As of December 31, 2013 we had the ability to borrow an incremental $351.8 million under our revolving credit facility, and we were in compliance with all the covenants. As of December 31, 2013, the Company's various subsidiaries had borrowings from banks totaling $40.1 million, of which $36.4 million relates to our Accounts Receivable Securitization Program, compared to $29.5 million and $27.7 million, respectively, at December 31, 2012. The remaining $3.7 million supports local working capital requirements. Accounts Receivable Securitization Program & Financing Receivables As discussed above, we have the ability to use our Accounts Receivable Securitization Program as one of several means to manage our liquidity. Under the terms of the Accounts Receivable Securitization Program that we entered into with Société Générale Bank Nederland N.V. (Société Générale) on September 23, 2009, we have the ability to sell our accounts receivable directly to Société Générale. The maximum funding from receivables that may be sold into the Accounts Receivable 36-------------------------------------------------------------------------------- Table of Contents Securitization Program is €80 million, following the voluntary reduction in January 2013 of the program from €100 million to €80 million; however, there can be no assurance that the Company will generate sufficient eligible receivables to access the maximum availability. The original term of the Accounts Receivable Securitization Program was for one year, with the possibility of four additional annual extensions, assuming the Company and the participating sellers are in compliance with the applicable covenants. The Company extended the Accounts Receivable Securitization Program in September 2013 for one additional year. During the year ended December 31, 2013, the Company sold all of its eligible receivables into the Accounts Receivable Securitization Program. The sold receivables were removed from the balance sheet in accordance with the guidance under ASC 860, "Transfers and Servicing". The total amount of receivables sold under the Accounts Receivable Securitization Program during the year ended December 31, 2013 was €790.8 million ($1,050.6 million at weighted average 2013 exchange rates), compared to €731.7 million ($941.1 million at weighted average 2012 exchange rates) during the year ended December 31, 2012. The amount of eligible receivables sold and outstanding at December 31, 2013 amounted to €75.0 million ($103.6 million at December 31, 2013 exchange rates) compared to €67.4 million ($89.1 million at December 31, 2012 exchange rates) in the prior year. As a result of the sale, accounts receivable decreased by $103.6 million and cash and cash equivalents increased by $51.5 million in 2013, compared to $89.1 million and $51.7 million, respectively, in 2012. The remaining amount of proceeds of $52.1 million is a subordinated deposit, before the effect of cash collections, with Société Générale Bank Nederland N.V. at December 31, 2013, compared to $37.4 million at December 31, 2012. As a result of the Company's access to the cash collections of the sold receivables, the Company collected $53.9 million of additional cash as of December 31, 2013. Of these cash receipts, $36.4 million is classified on the consolidated balance sheet as loans payable to bank. The remaining amount of $17.5 million reduced the subordinated deposit to $34.6 million, the balance of which is classified as restricted cash on the consolidated balance sheet at December 31, 2013. As of December 31, 2013, the Company also had pledged unsold receivables under the Accounts Receivable Securitization Program of €3.2 million ($4.4 million at December 31, 2013 exchange rates), compared to €9.8 million ($12.9 million at December 31, 2012 exchange rates) in 2012. The fair value of the receivables sold equaled the carrying cost at time of sale, and no gain or loss was recorded as a result of the sale. The Company estimated the fair value of sold receivables using Level 3 inputs and based the estimate on historical and anticipated performance of similar receivables, including historical and anticipated credit losses (if any). As part of the Accounts Receivable Securitization Program, the Company continues to service the receivables. The Company sells the receivables at face value, but receives actual funding net of the subordinated deposit account until collections are received from customers for the receivables sold. The Company is exposed to the credit losses of sold receivables up to the amount of its subordinated deposit account at each settlement date. Credit losses for receivables sold and past due amounts outstanding at December 31, 2013 were both immaterial. Servicing fees paid for the program were $0.8 million for the year ended December 31, 2013. Other financing receivables include sales to reputable State Owned and Public Enterprises in China that are settled through notes receivable which are registered and endorsed to the Company. These notes receivable are fully secured and generally have contractual maturities of six months or less. These guaranteed notes are available to be discounted with banking institutions in China or transferred to suppliers to settle liabilities. The total amount of notes receivable discounted or transferred for the years ended December 31, 2013, 2012 and 2011 were $42.8 million, $33.3 million and $62.8 million, respectively. There were no expenses for the year ended December 31, 2013, compared to $0.1 million and $0.6 million for the years ended December 31, 2012 and 2011, respectively, which are included in "other non-operating expense, net." The fair value of these guaranteed notes receivable equal their carrying amounts of $51.4 million and $41.2 million as of December 31, 2013 and December 31, 2012, respectively, and are included in "other current assets" on the consolidated balance sheets. The Company monitors the credit quality of both the drawers of the draft and guarantors on a monthly basis by reviewing various factors such as payment history, level of state involvement in the institution, size, national importance as well as current economic conditions in China. Since the Company has not experienced any historical losses nor is the Company expecting future credit losses based on a review of the various credit quality indicators described above, we have not established a loss provision against these receivables as of December 31, 2013 or 2012. 37-------------------------------------------------------------------------------- Table of Contents Factoring Program On April 15, 2009, we entered into a €35 million factoring program, which has a term of five years, in respect to accounts receivable from one of our customers. To date, we have not utilized this program. Derivative Instruments and Hedging Activities We recognize all derivative financial instruments in the consolidated balance sheet at fair value using Level 2 inputs and these are classified as "other current assets," "other assets," "other accrued liabilities" or "other liabilities" on the consolidated balance sheet. Level 2 inputs used by the Company in valuing its derivative instruments include model-based valuation techniques for which all significant assumptions are observable in the market. The earnings impact resulting from changes in the fair value of derivative instruments is recorded in the same line item in the consolidated statement of operations as the underlying exposure being hedged or in accumulated other comprehensive income (AOCI) for derivatives that qualify and have been designated as cash flow hedges or hedges of a net investment in a foreign operation. Any ineffective portion of a financial instrument's change in fair value is recognized in earnings together with changes in the fair value of any derivatives not designated as relationship hedges. Foreign exchange contracts are used by us to offset the earnings impact relating to the variability in exchange rates on certain monetary assets and liabilities denominated in non-functional currencies and have not been designated as relationship hedges. As of December 31, 2013, forward contracts for an aggregate notional amount of €61.8 million ($85.3 million at December 31, 2013 exchange rates) were outstanding with an average duration of one month. These foreign exchange contracts have offset the revaluation of assets and liabilities and resulted in a net non-operating loss of $0.1 million for the year ended December 31, 2013. The majority of these exchange contracts were entered into on December 30, 2013 and have a fair value of $0.1 million as of December 31, 2013. Off-Balance Sheet Arrangements Please see the disclosure above in "Accounts Receivable Securitization Program". Contractual Obligations Following is a summary of contractual obligations as of December 31, 2013. Aggregate Contractual Obligations As of December 31, 2013 (in millions) Payments due by period (1) Contractual Obligation Total 2014 2015 and 2016 2017 and 2018 Beyond 2018 Debt obligations (2) $ 87.1 $ 40.1 $ 47.0 $ - $ - Operating lease obligations (3) 65.5 17.2 20.8 14.4 13.1 Tax indemnifications (4) 9.2 - - - - Purchase obligations (5) 194.0 194.0 - - - Unfunded pension and post-retirement benefits (6) 313.0 31.0 62.5 62.0 157.5 Tax liabilities (7) 45.3 - - - - Total $ 714.1 $ 282.3 $ 130.3 $ 76.4 $ 170.6 (1) The amounts and timing of such obligations, as shown in the table may vary substantially from amounts that will actually be paid in future years. For example, the actual amount to be paid under debt obligations under our revolving credit facility will depend on the amount of debt outstanding under the agreement in each year. (2) Amounts shown for debt obligations include an immaterial amount of associated interest based on the December 31, 2013 rates applicable to each type of debt. (3) Amounts include future rental commitments under all non-cancelable operating leases in effect at December 31, 2013. (4) Amounts are probable and estimable costs that the Company is responsible for under a Tax Sharing Agreement between Trane and WABCO. The entire $9.2 million is classified as long term and the Company is currently unable to estimate the timing of the potential amounts to be paid. 38-------------------------------------------------------------------------------- Table of Contents (5) In the normal course of business we expect to purchase approximately $1.7 billion in 2014 of materials and services, and estimate that on average no more than approximately $194.0 million is outstanding at any one time in the form of legally binding commitments. We spent approximately $1.6 billion, $1.5 billion and $1.7 billion on materials and services in 2013, 2012 and 2011, respectively. (6) Amounts represent undiscounted projected benefit payments to WABCO's unfunded plans over the next ten years, as well as expected contributions to funded pension plans for 2014. The expected benefit payments are estimated based on the same assumptions used to measure our accumulated benefit obligation at the end of 2013 and include benefits attributable to estimated future employee service of current employees. (7) Amounts represent the Company's unrecognized tax provisions potentially owed to tax authorities as described in Note 15 of Notes to the Consolidated Financial Statements. The total liability of $45.3 million is classified as long term and includes interest of $6.0 million. The Company is currently unable to estimate the timing of potential amounts to be paid. Capital Expenditures We believe our capital spending in recent years has been sufficient to maintain efficient production capacity, to implement important product and process redesigns and to expand capacity to meet increased demand. Productivity projects have freed up capacity in our manufacturing facilities and are expected to continue to do so. We expect to continue investing to expand and modernize our existing facilities and invest in our facilities to create capacity for new product development and, as discussed above, we expect to increase our capital spending in 2014 due to the construction of a new plant in Poland. Pending Adoptions of Recently Issued Accounting Standards We do not expect the pending adoption of recently issued accounting standards to have an impact on the consolidated financial statements. Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of financial statements in conformity with those accounting principles requires us to make judgments and estimates that affect the amounts reported in the consolidated financial statements and accompanying notes. Those judgments and estimates have a significant effect on the consolidated financial statements because they result primarily from the need to make estimates about the effects of matters that are inherently uncertain. Actual results could differ from those estimates. We frequently re-evaluate our judgments and estimates that are based upon historical experience and on various other assumptions that we believe to be reasonable under the circumstances. We believe that of our significant accounting policies (see Note 2 of Notes to the Consolidated Financial Statements), the ones that may involve a higher degree of uncertainty, judgment and complexity are allowance for doubtful accounts, inventory reserves, goodwill, stock-based compensation, post-retirement benefits, warranties, income taxes, and contingencies. Allowance for Doubtful Accounts - The Company performs ongoing credit evaluations of its customers. In determining the allowance for doubtful accounts, on a monthly basis, WABCO analyzes the aging of accounts receivable, historical bad debts, customer creditworthiness, availability of credit insurance and current economic trends. Though management considers the valuation of the allowances proper and adequate, changes in the economy and/or deterioration of the financial condition of the Company's customers could affect the reserve balances required. Historically, this valuation has proved to be a reasonable estimate of the Company's experience with doubtful debts. Inventory Reserves - On a quarterly basis, the Company tests its inventory for slow moving and obsolete stock by considering both the historical and expected sales and the Company will record a provision, if needed. Historically, this policy has given a close approximation of the Company's experience with slow moving and obsolete inventory. From time to time unusual buying patterns or shifts in demand may cause large movements in the reserve. Goodwill - The Company has a significant amount of goodwill on its balance sheet that is not amortized, but subject to impairment tests each fiscal year on October 1 or more often when events or circumstances indicate that the carrying amount of goodwill may not be recoverable. The Company's impairment tests utilize the two-step approach. The first step of the goodwill impairment test compares fair value of a reporting unit with its carrying amount, including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is not considered impaired and thus the second step of the impairment test is unnecessary. If the carrying amount of a reporting unit exceeds its fair value, the second 39-------------------------------------------------------------------------------- Table of Contents step of the goodwill impairment test shall be performed to measure the amount of impairment loss, if any. The second step of the goodwill impairment test compares the implied fair value of reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss shall be recognized in an amount equal to that excess. The recoverability of goodwill is measured based on one reporting unit for the total Company. WABCO's plants, engineering, technical support, distribution centers and other support functions are shared among various product families and serve all distribution channels with many customers. Based on the organizational structure, as well as the nature of financial information available and reviewed by the Company's chief operating decision maker to assess performance and make decisions about resource allocations, the Company has concluded that its total WABCO operations represent one reportable unit and that WABCO's performance and future net cash flow perspectives are best understood and assessed as such. In order to approximate the fair value of the reporting unit for purposes of testing recoverability, we use the total market capitalization of the Company, a market approach, which is then compared to the total book value of the Company. In the event the Company's fair value has fallen below book value, the Company will compare the estimated fair value of goodwill to its book value. If the book value of goodwill exceeds the estimated fair value of goodwill, the Company will recognize the difference as an impairment loss in operating income. There has been no impairment of goodwill during 2013, and the Company's goodwill was not at risk for failing the first step of its impairment test. Stock-Based Compensation - The Company measures and recognizes in its consolidated statement of operations the expense associated with all share-based payment awards made to employees and directors including stock options, restricted stock units, performance stock units and restricted stock grants based on estimated fair values. The Company utilizes the Black-Scholes option valuation model to measure the amount of compensation expense to be recognized for each option award. There are several assumptions that must be made when using the Black-Scholes model such as the expected term of each option, the expected volatility of the stock price during the expected term of the option, the expected dividends to be paid and the risk free interest rate expected during the option term. The risk free interest rate is based on the yield of U.S. Treasury securities that correspond to the expected holding period of the options. WABCO reviewed the historic volatility of its common stock over a four year period, the common stock of its peer group over a five year period, and the implied volatility for at the money options to purchase shares of its common stock. The five-year historical volatility period was selected since that period corresponds with the expected holding period. Based on this data, the Company chose to use a weighted average of the implied volatility of WABCO, the most recent four year historical volatility of WABCO and the median most recent one year historical volatility of WABCO's peer group prior to the spin-off date. The expected holding period was calculated by reviewing the historical exercise pattern of all holders that were granted options and the exercise behavior of officers versus non-officers. The results of the analysis support one expected holding period for all groups of employees. The expected forfeiture rate was determined based on the historical stock option forfeiture data of the Company. The dividend yield was based on an expected future dividend rate for the period at the time of grant. Of these assumptions, the expected term of the option and expected volatility of WABCO's common stock are the most difficult to estimate since they are based on the exercise behavior of employees and expected performance of WABCO's stock. An increase in the volatility of WABCO's stock will increase the amount of compensation expense on new awards. An increase in the holding period of options will also cause an increase in compensation expense. Dividend yields and risk-free interest rates are less difficult to estimate. An increase in the dividend yield will cause a decrease in expense and an increase in the risk-free interest rate will increase compensation expense. Commencing in 2013, the Company replaced stock options with performance stock units (PSUs), the vesting of which would occur at levels ranging from none to 200% of the number of granted PSUs depending upon the achievement of three-year cumulative earnings per share goals approved by the Compensation, Nominating and Governance Committee of the Board of Directors. See also Note 6 of Notes to the Consolidated Financial Statements for further discussion. Post-Retirement Benefits - The Company has significant pension and post-retirement benefit costs and liabilities that are developed from actuarial valuations. Inherent in these valuations are key assumptions including discount rates, expected return on plan assets, mortality rates, merit and promotion increases and the health care cost trend rate. The Company is required to consider current market conditions, including changes in interest rates and health care costs, in making its assumptions. Changes in the related pension and post-retirement benefit costs or liabilities may occur in the future due to changes in the assumptions. The assumptions as to the expected long-term rates of return on plan assets are based upon the composition of plan assets, historical long-term rates of return on similar assets and current and expected market conditions. The discount rate used for U.S. plans reflects the market rate for high-quality fixed-income investments on the Company's annual measurement date (December 31) and is subject to change each year. The discount rate was determined by matching, on an approximate basis, the coupons and maturities for a portfolio of corporate bonds (rated AA or better by Moody's Investor Services) to the expected plan benefit payments defined by the projected benefit obligation. The discount rates used for plans outside the United States are based on a combination of relevant indices regarding corporate and government securities, the duration of the liability and appropriate judgment. A decrease of one percentage point in the assumed rate of 40-------------------------------------------------------------------------------- Table of Contents return on plan assets and a decrease of one percentage point in the discount rate applied to projected benefit obligations would increase annual pension expense by approximately $7.6 million. An increase of one percentage point in the assumed health care cost trend rate in each future year would not materially increase annual health insurance costs. The impact of Health Care Reform legislation in the United States. is immaterial to WABCO. See the disclosures about pension and post-retirement obligations, the composition of plan assets, assumptions and other matters in Note 12 of Notes to the Consolidated Financial Statements. Warranties - Products sold by WABCO are covered by a basic limited warranty with terms and conditions that vary depending upon the product and country in which it was sold. The limited warranty covers the equipment, parts and labor (in certain cases) necessary to satisfy the warranty obligation generally for a period of two years. Estimated product warranty expenses are accrued in cost of goods sold at the time the related sale is recognized. Estimates of warranty expenses are based primarily on warranty claims experience and specific customer contracts. Warranty expenses include accruals for basic warranties for product sold, as well as accruals for product recalls, service campaigns and other related events when they are known and estimable. To the extent we experience changes in warranty claim activity or costs associated with servicing those claims, our warranty accrual is adjusted accordingly. Warranty accrual estimates are updated based upon the most current warranty claims information available. The Company's warranty costs as a percentage of net sales totaled 0.8% in 2013, 1.1% in 2012 and 1.5% in 2011. We do not expect this percentage to change materially in the near future. See Note 14 of Notes to the Consolidated Financial Statements for a three-year summary of warranty costs. Income taxes - We record a valuation allowance to reduce our deferred tax assets to the amount that we believe is more likely than not to be realized. While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to decrease the net deferred tax assets would be charged to income in the period such determination was made. Likewise, should we determine that we would be able to realize our deferred tax assets in the future in excess of our net recorded amount, an adjustment to increase the net deferred tax assets would increase income in the period such determination was made. We calculate a valuation allowance in accordance with the provisions of ASC 740, "Income Taxes," which requires an assessment of both positive and negative evidence regarding the realizability of these deferred tax assets, when measuring the need for a valuation allowance. We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. In determining net deferred tax assets and valuation allowances, management is required to make judgments and estimates related to projections of profitability, the timing and extent of the utilization of net operating loss carry-forwards, applicable tax rates and tax planning strategies. We review the valuation allowance quarterly and maintain it until sufficient positive evidence exists to support a reversal. In 2013, the Company recorded a tax benefit of $178.4 million for a release at the end of the year of a valuation allowance related to management's determination that it is more likely than not that the Company will realize its deferred tax asset in a foreign jurisdiction. In particular, evidence such as our historical operating profits resulting in a cumulative profitable position during the three-year period ending on December 31, 2013, the receipt of an exceptional EC fine refund in the fourth quarter of 2013 and projected operating profits represented sufficient positive evidence to release a full valuation allowance at the end of 2013 on the deferred tax asset under ASC 740. Management has also determined that it is more likely than not that it will not realize $10.1 million of its deferred tax assets in other foreign jurisdictions since evidence such as historical operating profits resulted in a cumulative loss position during the most recent three-year period ending on December 31, 2013 and lack of projected earnings provided sufficient negative evidence to record a valuation allowance against such deferred tax assets related to carryforwards for net operating losses and notional interest deductions. The release of the $178.4 million valuation allowance was recorded as an income tax benefit at December 31, 2013 which significantly reduced our effective tax rate, resulting in a negative effective tax rate. We expect our effective tax rate to increase in subsequent periods following this release of the valuation allowance. Our net income and effective tax rate will be negatively affected in periods following this release. However, any valuation allowance release will not affect the amount of cash paid for income taxes. We also estimate our effective income tax rate quarterly, considering all known factors and the estimated effects of future events or tax planning strategies that can cause that rate to vary from the statutory rate. Estimating the outcome of future events is inherently uncertain and final resolution of those events can cause the effective tax rate to vary significantly. In addition, changes in U.S. or foreign tax laws or rulings may have a significant impact on our effective tax rate. 41-------------------------------------------------------------------------------- Table of Contents A tax position is a position in a previously filed tax return or a position expected to be taken in a future tax filing that is reflected in measuring current or deferred income tax assets and liabilities. Tax positions shall be recognized only when it is more likely than not (likelihood of greater than 50%), based on technical merits, that the position will be sustained. Tax positions that meet the more likely than not threshold should be measured using a probability weighted approach as the largest amount of tax benefit that is greater than 50% likely of being realized upon settlement. Whether the more-likely-than-not recognition threshold is met for a tax position, is a matter of judgment based on the individual facts and circumstances of that position evaluated in light of all available evidence. Tax positions are not permitted to be recognized, derecognized, or remeasured due to changes subsequent to the balance sheet date, but prior to the issuance of the financial statements. Rather, these changes are recorded in the period the change occurs with appropriate disclosure of such subsequent events, if significant. The Company accrues interest and penalties related to unrecognized tax benefits in income tax expense. In situations where the Company has tax deductions that would otherwise increase a deferred tax asset related to net operating losses, a tax deduction which is treated as an uncertain tax position is recorded as a reduction of the deferred tax asset on the balance sheet. In this regard, although the uncertain tax position is not reflected as an unrecognized tax benefit in the balance sheet as a recorded liability, it is disclosed in the tabular rollforward for unrecognized tax benefits in Note 15 of Notes to the Consolidated Financial Statements. Contingencies - We are subject to proceedings, lawsuits and other claims related to products and other matters. We are required to assess the likelihood of any adverse judgments or outcomes to these matters as well as potential ranges of probable and reasonably possible losses. A determination of the amount of liability to be recorded, if any, for these contingencies is made after careful analysis of each individual issue. It is reasonably possible that the Company could incur losses in excess of the amounts accrued. Although this amount cannot be estimated, we believe that any additional losses would not have a material adverse impact on the consolidated financial statements. In conjunction with the Tax Sharing Agreement, as further discussed in Note 16 of Notes to the Consolidated Financial Statements, WABCO is responsible for certain tax and indemnification liabilities. These liabilities include indemnification liabilities to Trane of $9.2 million. Cyclical and Seasonal Nature of Business The industry in which we operate is cyclical. Approximately 71% of our sales are for newly manufactured trucks, buses and trailers, the production of which follows long investment cycles and are impacted by macro economic factors and legislation. Global commercial vehicle production was consistently growing since 2001. In the fourth quarter of 2008, however, the global commercial vehicle markets started to experience a significant decline that was unprecedented in its breadth, depth and speed which continued through 2009. All markets experienced favorable growth in 2010 while our most developed markets again experienced favorable growth in 2011. 2012 saw most markets decline with only our markets in North America and Japan experiencing growth. In 2013 we saw mixed performances across the various markets with some geographies up double digit while others were down double digit. The overall market ticked up slightly in 2013. Our markets are difficult to predict; however, in 2014 we are again anticipating mixed markets where most are expected to be flat to down versus 2013 with the exception of the North America market which is expected to grow. The continued adoption of new technologies by truck and bus manufacturers helps our business outperform the rate of truck and bus production over the longer term. The commercial vehicle industry is not subject to material seasonal impacts. |