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FREESCALE SEMICONDUCTOR, LTD. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following is a discussion and analysis of our results of operations for the three and nine months ended October 3, 2014 and September 27, 2013 and our financial condition as of October 3, 2014 and December 31, 2013. The following discussion of our results of operations and financial condition should be read in conjunction with our consolidated financial statements and the notes in "Item 8: Financial Statements and Supplementary Data" of our Annual Report on Form 10-K filed with the Securities and Exchange Commission on February 10, 2014 ("Annual Report"). This discussion contains forward looking statements and involves numerous risks and uncertainties, including, but not limited to, those described in the "Risk Factors" in Part I, Item 1A of our Annual Report. Actual results may differ materially from those contained in any forward looking statements. Freescale Semiconductor, Ltd. and its wholly-owned subsidiaries, including Freescale Semiconductor, Inc. ("Freescale Inc."), are collectively referred to as the "Company," "Freescale," "we," "us" or "our," as the context requires. Our Business. We are a global leader in microcontrollers and digital networking processors. These embedded processors form the foundation of emerging technologies, including the Internet of Things, a network of smart devices and electronics that help make our lives safer and more productive. We complement our embedded processors with analog, sensor and radio frequency (RF) devices to help provide highly integrated solutions that streamline customer development efforts and shorten their time to market. An embedded processing solution is the combination of embedded processors, complementary semiconductor devices and software. Our embedded processor products include microcontrollers (MCUs), single- and multicore microprocessors, digital signal controllers, applications processors and digital signal processors. Our programmable devices, along with software, provide the core functionality of electronic systems, adding essential control and intelligence, enhancing performance and optimizing power usage while lowering system costs. A key element of our strategy is to combine our embedded processors, complementary semiconductor devices and software to offer highly integrated solutions to our customers to simplify their development efforts and shorten their time to market. In addition, we are expanding our customer base by more aggressively leveraging the unique breadth and depth of our product portfolio. We have a heritage of innovation and product leadership spanning over 50 years and have an extensive intellectual property portfolio. We sell our products directly to original equipment manufacturers, distributors, original design manufacturers and contract manufacturers. We have built close customer relationships through years of collaborative product development. The trend of increasing connectivity and the need for enhanced intelligence in existing and new markets are the primary drivers of the growth of embedded processing solutions in electronic devices. The majority of our net sales is derived from five product groups. Our Microcontrollers product group represented 21% of our total net sales in the third quarters of both 2014 and 2013. MCUs are a self-contained embedded control system with processors, memory and peripherals on a chip. Combined with applications processors, we deliver solutions for automotive, industrial, smart energy, healthcare and multimedia applications. Our Digital Networking product group represented 23% and 22% of our total net sales in the third quarter of 2014 and 2013, respectively. We offer a scalable portfolio of multicore communication processors and system-on-a-chip solutions for the networking and communication markets. Our products provide enhanced intelligence and connectivity to the telecommunications equipment, network infrastructure and general embedded connectivity nodes that are enabling the Internet of Things. Our Automotive MCU product group represented 25% of our total net sales in the third quarters of both 2014 and 2013. Our Automotive MCUs are developed specifically for the critical performance and quality requirements of the automotive industry. We are enabling the latest developments in powertrain, advanced safety, body and infotainment applications. Our Analog and Sensors product group represented 17% of our total net sales in the third quarters of both 2014 and 2013. Our analog, mixed-signal analog and sensor products help capture, manage and transmit data from the real-world environment for embedded processing applications in the automotive, industrial and consumer markets. These devices complement our MCUs in applications for robotics, factory automation, automotive radar, braking and airbag control. Our RF product group represented 13% and 8% of our total net sales in the third quarter of 2014 and 2013, respectively. We supply RF high-power products into the cellular infrastructure market and are expanding our portfolio to leverage our RF technology leadership into the military, appliance and automotive markets. Conditions Impacting Our Business. Our business results are impacted by demand for electronic content in automobiles, networking and wireless infrastructure equipment, industrial and factory automation and consumer electronic devices. We operate in an industry that is cyclical and subject to technological changes, product obsolescence, price erosion, evolving standards, short product life-cycles, changing customer inventory levels and fluctuations in product supply and demand. Our total net sales in the third quarter of 2014 increased by $22 million, or 2%, compared to the second quarter of 2014. Revenue growth led by LTE wireless basestation expansion, particularly in China, was partially offset by reduced enterprise sales and lower revenue into the automotive end market. The decline in automotive sales was in line with historical seasonality. Our gross margin increased 120 basis points in the third quarter of 2014 as compared to the second quarter of 2014, due primarily to increasing revenues, favorable product mix among our product groups, operational efficiencies and procurement 31-------------------------------------------------------------------------------- Table of Contents savings. Capital expenditures were $63 million, or 5% of net sales, in the third quarter of 2014 and $56 million, or 5% of net sales, in the second quarter of 2014. This reflects continued capacity increases for our RF and microcontroller products. Net sales in the near term will depend on general global economic activity and our ability to meet unscheduled or temporary increases in demand in our target markets, among other factors. We anticipate that our total net sales will decline on a sequential basis as compared to the third quarter of 2014 in excess of normal seasonality due to decreases in demand in enterprise spending, seasonal automotive weakness and our customers managing their inventory levels. Accordingly, we expect our gross margin to decline into the fourth quarter as we monitor utilization rates and activity in our back-end manufacturing facilities. For more information on trends and other factors affecting our business, refer to Part I, Item 1A: "Risk Factors" included in our Annual Report. Capital Restructuring Activities. During the first quarter of 2014, we completed an equity issuance from which we received net proceeds totaling approximately $717 million, which were used, along with cash on hand, to redeem $680 million of outstanding indebtedness and pay related call premiums. Also during the first quarter of 2014, Freescale Inc. completed a debt refinancing transaction which extended the maturity of $347 million of our indebtedness and reduced the interest rate on $2.7 billion of indebtedness. During the third quarter of 2014, Freescale Inc. redeemed $100 million principal amount of outstanding indebtedness. The combined impact of these transactions reduced our annualized cash interest expense by approximately $85 million based on current interest rates. Subsequent to the end of the third quarter of 2014, Freescale Inc. delivered notice of the redemption of an incremental $100 million principal amount of indebtedness to occur during the fourth quarter of 2014, which will decrease our cash interest expense by an incremental $8 million on an annual basis. (Refer to Note 4, "Debt," in the accompanying Condensed Consolidated Financial Statements and "Liquidity and Capital Resources - Financing Activities" for additional discussion of these transactions.) 32-------------------------------------------------------------------------------- Table of Contents Results of Operations for the Three and Nine Months Ended October 3, 2014 and September 27, 2013 Three Months Ended Nine Months Ended October 3, September 27, October 3, September 27, (in millions, unaudited) 2014 2013 2014 2013 Orders $ 1,206 $ 1,116 $ 3,578 $ 3,200 Net sales $ 1,213 $ 1,085 $ 3,531 $ 3,104 Cost of sales 651 612 1,927 1,792 Gross margin 562 473 1,604 1,312 Selling, general and administrative 122 120 376 346 Research and development 213 191 642 560 Amortization expense for acquired intangible assets 4 3 11 10 Reorganization of business and other 8 2 25 10 Operating earnings 215 157 550 386 Loss on extinguishment or modification of long-term debt (10 ) (1 ) (69 ) (82 ) Other expense, net (82 ) (118 ) (268 ) (363 ) Earnings (loss) before income taxes 123 38 213 (59 ) Income tax (benefit) expense (2 ) 15 25 31 Net earnings (loss) $ 125 $ 23 $ 188 $ (90 ) Percentage of Net Sales Three Months Ended Nine Months Ended October 3, September 27, October 3, September 27, (unaudited) 2014 2013 2014 2013 Orders 99.4 % 102.9 % 101.3 % 103.1 % Net sales 100.0 % 100.0 % 100.0 % 100.0 % Cost of sales 53.7 % 56.4 % 54.6 % 57.7 % Gross margin 46.3 % 43.6 % 45.4 % 42.3 % Selling, general and administrative 10.1 % 11.1 % 10.6 % 11.1 % Research and development 17.6 % 17.6 % 18.2 % 18.0 % Amortization expense for acquired intangible assets 0.3 % 0.3 % 0.3 % 0.4 % Reorganization of business and other 0.6 % 0.1 % 0.7 % 0.4 % Operating earnings 17.7 % 14.5 % 15.6 % 12.4 % Loss on extinguishment or modification of long-term debt * * * * Other expense, net * * * * Earnings (loss) before income taxes 10.1 % 3.5 % 6.0 % * Income tax (benefit) expense * 1.4 % 0.7 % 1.0 % Net earnings (loss) 10.3 % 2.1 % 5.3 % * * Not meaningful. Three and Nine Months Ended October 3, 2014 Compared to Three and Nine Months Ended September 27, 2013 Net Sales Our net sales increased by $128 million, or 12%, in the third quarter of 2014 compared to the third quarter of 2013 and by $427 million, or 14%, in the first nine months of 2014 compared to the first nine months of 2013. Our orders increased 8% in the third quarter of 2014 compared to third quarter of 2013 and by 12% in the first nine months of 2014 compared to the first nine months of 2013 driven by growth across all of our product groups and end markets. This sales growth was partially offset by lower intellectual property revenue and declines in sales of legacy products into the cellular market. Distribution sales were 33-------------------------------------------------------------------------------- Table of Contents approximately 27% of net sales in both the third quarter and first nine months of 2014, compared to 25% of net sales in both the third quarter and first nine months of 2013. Distribution sales increased $57 million compared to the third quarter of 2013 and $173 million compared to the first nine months of 2013. Distribution inventory, in dollars, was 9.6 weeks at October 3, 2014, compared to 9.1 weeks at December 31, 2013 and 9.2 weeks at September 27, 2013. Net sales by product group for the three and nine months ended October 3, 2014 and September 27, 2013 were as follows: Three Months Ended Nine Months Ended October 3, September 27, October 3, September 27, (in millions, unaudited) 2014 2013 2014 2013 Microcontrollers $ 250 $ 230 $ 719 $ 606 Digital Networking 281 238 821 669 Automotive MCU 303 270 915 796 Analog & Sensors 201 181 604 546 RF 157 89 390 256 Other 21 77 82 231 Total net sales $ 1,213 $ 1,085 $ 3,531 $ 3,104 Microcontrollers Microcontrollers' net sales increased by $20 million, or 9%, in the third quarter of 2014 and $113 million, or 19%, in the first nine months of 2014 compared to the prior year periods driven by growth in both microcontrollers and applications processors. The increase in microcontroller revenue was largely due to increasing sales of our 32-bit microcontrollers sold through distribution into several markets including medical and industrial. The increase in applications processors revenue was driven by increased sales both through distribution and into the worldwide automotive market. Digital Networking Digital Networking's net sales increased by $43 million, or 18%, in the third quarter of 2014 and $152 million, or 23%, in the first nine months of 2014 compared to the prior year periods. Sales growth in both periods was broad-based with higher sales of service provider equipment including wireless basestations in China, general embedded products sold into the distribution channel and next generation enterprise systems. Automotive MCU Automotive MCU's net sales increased by $33 million, or 12%, in the third quarter of 2014 and $119 million, or 15%, in the first nine months of 2014 compared to the prior year periods. The growth was due to an increase in worldwide automotive production, growth in vehicle semiconductor content along with increased sales into the distribution channel. Analog & Sensors Analog and Sensors' net sales increased by $20 million, or 11%, in the third quarter of 2014 and $58 million, or 11%, during the first nine months of 2014 compared to the prior year periods. Approximately 85% of our Analog and Sensors sales are into the automotive market. We experienced higher net sales due to growth in the automotive market for both our Analog and Sensor products due primarily to increased semiconductor content driven by fuel efficiency requirements and safety features coupled with an increase in worldwide automotive production. RF RF's net sales increased by $68 million, or 76%, in the third quarter of 2014 and $134 million, or 52%, in the first nine months of 2014 compared to the prior year periods driven by continued growth in next generation wireless basestation spending, primarily in China. Our RF product group represented 13% and 8% of our total net sales in the third quarter of 2014 and 2013, respectively, and 11% and 8% of our total net sales in the first nine months of 2014 and 2013, respectively. The growth in RF net sales continues to be impacted by supply constraints associated with demand related to wireless basestation expansion. The Company is investing in capital and working with suppliers to improve supply in the fourth quarter of 2014 and into 2015. Other Other net sales decreased by $56 million, or 73%, in the third quarter of 2014 compared to the third quarter of 2014 and $149 million, or 65%, in the first nine months of 2014 compared to the first nine months of 2013 primarily due to lower intellectual property revenue and decreased cellular product sales. As a percentage of net sales, intellectual 34-------------------------------------------------------------------------------- Table of Contents property revenue was 1% for both the third quarter and first nine months of 2014 and 5% for both the third quarter and first nine months of 2013. Our intellectual property revenue during the third quarter and first nine months of 2013 significantly exceeded our historical average of approximately 3% of net sales and benefited from certain agreements entered into during 2012. The revenue stream attributed to these agreements ended in the fourth quarter of 2013. Agreements of similar size may not occur in the future, and we expect lower levels of intellectual property revenue to persist. Gross Margin Our gross margin increased by $89 million, or 19%, during the third quarter of 2014 compared to the third quarter of 2013 which was primarily driven by a 12% increase in our net sales. As a percentage of net sales, gross margin was 46.3% in the third quarter of 2014, reflecting an increase of 270 basis points compared to the third quarter of 2013. Our gross margin increased by $292 million, or 22%, during the first nine months of 2014 compared to the first nine months of 2013 which was primarily driven by a 14% increase in our net sales. As a percentage of net sales, gross margin was 45.4% in the first nine months of 2014, reflecting an increase of 310 basis points compared to the first nine months of 2013. Improvement in gross margin as a percentage of net sales was largely attributable to higher revenues, favorable product group mix and an increase in utilization of our manufacturing assets, which contributed to improvements in operating leverage of our fixed manufacturing costs. Front-end wafer manufacturing facility utilization improved from 89% during the third quarter of 2013 to 92% during the third quarter of 2014 and from 85% during the first nine months of 2013 to 91% during the first nine months of 2014 due to increased demand. The higher level of utilization has impacted our ability to meet customer demand for certain of our products. We expect to make further progress in the fourth quarter of 2014 and into 2015 to continue to better address this demand with the installation of additional capacity. Other factors benefiting gross margin in both periods included operational efficiencies and procurement savings. We also transitioned personnel from roles focusing on manufacturing cost reduction, factory closure and customer qualification efforts to roles supporting various new product development initiatives which had a positive impact on the year over year improvement in gross margin. These improvements were partially offset by lower intellectual property revenue, the impact of decreases in average selling prices resulting from our annual negotiations with our customers that went into effect during the first quarter of 2014, a decrease in cellular product net sales and higher incentive compensation. Selling, General and Administrative Our selling, general and administrative expenses increased by $2 million, or 2%, and $30 million, or 9%, in the third quarter and first nine months of 2014, respectively, compared to the prior year periods. These increases are due to additional resources and strategic spend on sales and marketing efforts and higher incentive compensation. Partially offsetting these increases included prior year charges for commitments to make charitable contributions to the Freescale Foundation, a nonprofit, 501(c)(3) organization during the second quarter of 2013 and the settlement of intellectual property litigation during the third quarter of 2013. As a percentage of net sales, our selling, general and administrative expenses for the third quarter of 2014 declined by 100 basis points to 10% compared to 11% in the third quarter of 2013 and were relatively flat for the first nine months of 2014 compared to the prior year period at approximately 11%. Research and Development Our research and development expenses increased by $22 million, or 12%, and $82 million, or 15%, in the third quarter and first nine months of 2014, respectively, compared to the prior year periods. These increases are related to additional investment in our strategic areas and next generation technologies, including the aforementioned personnel move from manufacturing cost reduction activities to roles focusing on new product development initiatives, along with higher incentive compensation. As a percentage of net sales, our research and development expenses were flat compared to the prior year periods at approximately 18% in both the third quarter and first nine months of 2014 and the comparative periods. Amortization Expense for Acquired Intangible Assets Amortization expense for acquired intangible assets related to tradenames/trademarks, customer relationships and developed technology remained relatively flat in the third quarter and first nine months of 2014 compared to the prior year periods as the majority of these intangible assets have reached a normalized amortization run rate. Reorganization of Business and Other During the third quarter of 2014, we recorded $4 million in charges related to on-going closure and decommissioning costs for our Toulouse, France manufacturing facility and demolition costs for our former manufacturing facility located in Sendai, Japan along with other charges. We also incurred $4 million in charges related to employee separation costs in connection with the continued execution of the reorganization plan initiated in 2012 (the "2012 Strategic Realignment"). (Refer to Note 9, "Reorganization of Business and Other," in the accompanying Condensed Consolidated Financial Statements for more information on the charges discussed in this section.) 35-------------------------------------------------------------------------------- Table of Contents Additionally, during the first nine months of 2014, we recorded an incremental $11 million net charge primarily related to employee separation costs in connection with the continued execution of the 2012 Strategic Realignment. We also incurred an incremental $6 million in charges during the first nine months of 2014 related to on-going closure and decommissioning costs for our Toulouse, France manufacturing facility and demolition costs for our former manufacturing facility located in Sendai, Japan. In the third quarter of 2013, we recorded $2 million in charges related to continued execution of the 2012 Strategic Realignment, comprised of costs associated with consolidating workspace in Austin, Texas and on-going closure and decommissioning costs for our Toulouse, France manufacturing facility. Additionally, during the first nine months of 2013, we recorded a net benefit of $9 million related to our Toulouse, France manufacturing facility, which included a benefit for proceeds received for the sale of certain of our equipment and machinery and a partially offsetting charge related to on-going closure and decommissioning costs for this site. We also recorded $17 million of charges related to (i) continued execution of the 2012 Strategic Realignment, (ii) exit costs for underutilized office space and (iii) charges related to indemnification provisions included in our current CEO's employment agreement. Loss on Extinguishment or Modification of Long-Term Debt During the third quarter and first nine months of 2014, we recorded charges of $10 million and $69 million, respectively, associated with the redemption of outstanding indebtedness during the third quarter of 2014 and debt redemption and refinancing transactions completed during the first quarter of 2014. These charges consisted of call premiums, the write-off of unamortized debt issuance costs and original issue discount ("OID") associated with the extinguished debt along with other expenses not eligible for capitalization. (Refer to Note 4, "Debt," in the accompanying Condensed Consolidated Financial Statements for further discussion about the transactions discussed in this section.) During the third quarter and first nine months of 2013, we recorded charges of $1 million and $82 million, respectively, in the accompanying Condensed Consolidated Statements of Operations associated with the redemption of outstanding indebtedness, the extinguishment and modification of existing debt and the issuance of new term loans. These charges consisted of the write-off of unamortized debt issuance costs, OID and other expenses not eligible for capitalization. Other Expense, Net Net interest expense in the third quarter and first nine months of 2014 included interest expense of $84 million and $274 million, respectively, partially offset by interest income of $3 million and $9 million, respectively. Net interest in the third quarter and first nine months of 2013 included interest expense of $120 million and $368 million, respectively, partially offset by interest income of $2 million and $4 million, respectively. The decrease in interest expense is due to the debt redemption accomplished with the net proceeds of the equity offering and the term loan refinancing transaction that occurred during the first quarter of 2014, as well as multiple refinancing transactions that occurred over the course of 2013. As a result of the capital structure changes, we have reduced our outstanding indebtedness by approximately $630 million and annualized interest expense by approximately $160 million, based on current interest rates, since the beginning of 2013, and reduced our weighted average cash interest rate from 6.6% at September 27, 2013 to 5.5% at October 3, 2014. Income Tax (Benefit) Expense During the third quarter and first nine months of 2014, we recorded an income tax (benefit) provision of $(2) million and $25 million, respectively, predominately related to our foreign operations. The income tax provision recorded during the third quarter and first nine months of 2014 included income tax (benefit) expense of $(4) million and $2 million, respectively, associated with discrete events. The discrete benefit in the third quarter of 2014 was largely related to (i) a partial release of foreign valuation allowance due to realizability of foreign research credits and (ii) the impact of adjustments necessary in connection with tax returns filed during the period. The discrete expense for the first nine months of 2014 also included an increase in the domestic valuation allowance resulting from the deferred tax asset created by the excess tax benefit from share-based awards during the period. Excluding discrete tax items, income tax expense was $2 million and $23 million in the third quarter and first nine months of 2014, respectively. These amounts primarily reflect tax expense attributable to income earned in non-U.S. jurisdictions. The decrease in tax expense in the third quarter and first nine months of 2014 as compared to the prior year periods is the result of increased foreign capital investment incentives partially offset by higher foreign tax rates attributable to certain of our non-U.S. operations. For the third quarter and first nine months of 2013, we recorded an income tax provision of $15 million and $31 million, respectively, which related primarily to our foreign operations. These provisions included $5 million and $4 million of tax expense during the third quarter and first nine months of 2013, respectively, associated with discrete events related primarily to withholding tax on intellectual property royalties. Excluding discrete tax items, income tax expense was $10 million and $27 million in the third quarter and first nine months of 2013, respectively. Although the Company is a Bermuda entity with a statutory income tax rate of zero, the earnings of many of the Company's subsidiaries are subject to taxation in the U.S. and other foreign jurisdictions. Our annual effective tax rate is 36-------------------------------------------------------------------------------- Table of Contents impacted by the mix of earnings and losses by taxing jurisdictions and was different from the Bermuda statutory rate of zero due to (i) income tax expense incurred by subsidiaries operating in jurisdictions that impose an income tax, (ii) the mix of earnings and losses across various taxing jurisdictions, (iii) a foreign capital investment incentive providing for enhanced tax deductions associated with capital expenditures in one of our foreign manufacturing facilities and (iv) the effect of valuation allowances and uncertain tax positions. We record minimal tax expense on our U.S. earnings due to valuation allowances recorded on substantially all the Company's U.S. net deferred tax assets, as we have incurred cumulative losses in the United States. (Refer to Note 7, "Income Taxes," in the accompanying Condensed Consolidated Financial Statements for more information regarding our income tax expense.) Liquidity and Capital Resources Cash and Cash Equivalents Of the $737 million of cash and cash equivalents at October 3, 2014, $249 million is attributable to our U.S. subsidiaries and $488 million is attributable to our foreign subsidiaries. The repatriation of the funds of these foreign subsidiaries could be subject to delay and potential tax consequences, principally with respect to withholding taxes paid in foreign jurisdictions. Operating Activities We generated cash flow from operations of $340 million and $203 million in the first nine months of 2014 and 2013, respectively. The increase in cash generated from operations is primarily attributable (i) higher sales and resulting profitability, (ii) lower cash paid for interest as a result of various debt redemption and refinancing transactions that occurred during 2013 and the first nine months of 2014, (iii) lower payments for employee severance and (iv) the strategic reduction of days of inventory on hand. These benefits were partially offset by an increase in receivables, as described below, higher payments for incentive compensation during the first nine months of 2014 along with higher intellectual property transaction proceeds and the receipt of a withholding tax rebate during the first nine months of 2013. Our days of inventory on hand decreased to 100 days at October 3, 2014 from 110 days at December 31, 2013 and 108 days at September 27, 2013. The decrease in days of inventory on hand from the prior year periods is due to consumption of inventory due to increased demand along with an overall focus on reducing days of inventory on hand to what we believe better corresponds to a balanced level of inventory for our business operating conditions. Our days sales outstanding increased to 45 days at October 3, 2014 from 33 days at December 31, 2013 and 36 days at September 27, 2013. The increase in days sales outstanding was the result of changes in payment terms implemented with specific customers and sales linearity during the third quarter of 2014. We expect days sales outstanding to remain near the level achieved during the third quarter of 2014 going forward. Our days purchases outstanding increased to 63 days at October 3, 2014 from 60 days at December 31, 2013 and 57 days at September 27, 2013, reflecting the timing of payments on our payables. Investing Activities Our net cash utilized for investing activities was $248 million and $152 million in the first nine months of 2014 and 2013, respectively. Our investing activities are driven primarily by capital expenditures and payments for purchased licenses and other assets. The cash utilized for investing activities in the first nine months of 2014 increased from the first nine months of 2013 and was predominately the result of increased capital expenditures, which were $175 million and $107 million for the first nine months of 2014 and 2013, respectively, and represented 5% and 3% of net sales, respectively. The higher capital expenditures are associated with increasing our manufacturing capacity to fulfill demand primarily from our RF and microcontroller customers. In addition, the cash paid for purchased licenses and other assets increased to $63 million from $50 million in the first nine months of 2013. The remaining $10 million of net cash utilized in the first half 2014 related primarily to a business acquisition completed during the second quarter of 2014 under which we acquired various intangible assets and inventory. The $6 million of proceeds from the sale of property, plant and equipment during the first nine months of 2013 were primarily attributable to the sale of certain tools and equipment located at our Toulouse, France manufacturing facility. Financing Activities Our net cash utilized for financing activities was $95 million and $57 million in the first nine months of 2014 and 2013, respectively. Cash flows utilized for financing activities in the first nine months of 2014 included $1.5 billion of payments on debt obligations comprised of i) payments of $718 million associated with the extinguishment of approximately $680 million of indebtedness along with $38 million of call premiums in connection with the use of proceeds from the equity offering completed during the first quarter of 2014, ii) payments of $597 million to lenders in connection with the $2.7 billion term loan refinancing transaction completed in the first quarter of 2014, iii) $27 million of amortization payments on the term loans and iv) payments of $109 million associated with the debt redemption that occurred during the third quarter of 2014. Cash provided by financing activities in the first nine months of 2014 included (i) $590 million of proceeds, net of transaction costs, related to funds received from lenders under the term loan refinancing and revolver modification transactions which occurred in the first quarter of 2014 and (ii) $717 million of net proceeds from the equity offering completed during the first quarter of 2014. Additionally, cash provided by financing activities in 2014 included $44 million of proceeds from the exercise of stock options and employee share purchase program (ESPP) share purchases and $5 million of excess tax benefits resulting from deductions 37-------------------------------------------------------------------------------- Table of Contents related to equity compensation in excess of compensation recognized for financial reporting. (Refer to Note 4, "Debt," in the accompanying Condensed Consolidated Financial Statements for further information regarding the debt transactions referenced in this section, Note 6, "Share and Equity-based Compensation," for further information on ESPP and stock options and Note 7, "Income Taxes," for further information on the tax benefit.) Cash flows related to financing activities in the first nine months of 2013 included (i) the prepayment of term loans totaling $2,711 million in connection with a debt refinancing transaction that occurred during the first quarter of 2013, (ii) the redemption of a portion of our indebtedness, including payment of the related call premiums, totaling $495 million in connection with a debt refinancing transaction that occurred during the second quarter of 2013, (iii) the redemption of $98 million of outstanding indebtedness during the third quarter of 2013, (iv) the classification of $782 million of our cash balance as restricted cash set aside for the redemption of indebtedness that was completed in the fourth quarter of 2013 as part of the refinancing transaction initiated during the third quarter along with (v) $15 million of capital lease and quarterly principal payments on the term loans. These cash outflows were partially offset by the receipt of (i) $2,707 million in net proceeds from the issuance of new term loans during the first quarter of 2013, (ii) $493 million in net proceeds from the issuance of additional indebtedness during the second quarter of 2013 and (iii) $782 million in net proceeds from the issuance of the 2021 Term Loan during the third quarter of 2013. Additionally, cash provided by financing activities in the first nine months of 2013 included $62 million of proceeds from the exercise of stock options and ESPP share purchases. First Quarter of 2014 Revolver Amendment and Debt Redemption Transactions On February 10, 2014, Freescale Inc. entered into an amendment to its existing revolving credit facility which became effective on February 18, 2014 (the "Q1 2014 Revolver Amendment"). Pursuant to the amendment, the existing revolving credit facility was replaced with a new revolving credit facility with an aggregate of $400 million of commitments (the "2019 Revolver"). The amendment also extended the maturity of the new revolving credit facility to February 1, 2019. The 2019 Revolver is subject to substantially the same terms and conditions as the existing revolving credit facility including the same pro rata split between United States Dollar and alternative currency availability. On March 20, 2014, after the requisite notice period, Freescale Inc. utilized approximately $717 million of net proceeds from the equity offering, along with cash on hand, to redeem $264 million of outstanding senior subordinated 10.125% notes due 2016, $57 million of outstanding senior unsecured floating rate notes due 2014 and $359 million of senior unsecured 8.05% notes due 2020 ("8.05% Unsecured Notes") and to pay call premiums of $38 million and accrued interest of $11 million. First Quarter of 2014 Term Loan Refinancing Transaction On March 4, 2014, Freescale, Inc. entered into an amendment and refinancing agreement to its senior secured term loan facilities, which effectively (i) lowered the interest rate of our existing $347 million senior secured term loan facility maturing in December 2016 (the "2016 Term Loan") and extended the maturity of the 2016 Term Loan to March 2020 to coincide with the maturity of its existing $2.37 billion senior secured term loan facility maturing in March 2020 (the "2020 Term Loan"), and (ii) lowered the interest rate applicable to the 2020 Term Loan in a transaction referred to as the "Q1 2014 Term Loan Refinancing Transaction." In connection with this transaction, (i) a portion of the existing lenders under the 2016 Term Loan agreed to the lower interest rate and extended maturity, (ii) a portion of the existing lenders under the 2020 Term Loan agreed to the lower interest rate, and (iii) Freescale used the proceeds of new senior secured term loans to refinance in full the 2016 Term Loan lenders and the 2020 Term Loan lenders who did not agree to the amendment. As a result, the amended 2016 Term Loan, the amended 2020 Term Loan and the new senior secured term loan, now have identical terms and are treated as a single tranche of senior secured term loans with an aggregate outstanding principal amount of $2.72 billion, collectively referred to as the "Amended 2020 Term Loan." The Amended 2020 Term Loan was issued at par, but was originally recorded at a $21 million discount, reflecting a portion of the remaining OID previously attributable to the 2020 Term Loan which was deemed exchanged for the Amended 2020 Term Loan. A portion of the proceeds from the issuance of the Amended 2020 Term Loan were used to prepay portions of the 2016 and 2020 Term Loans, thus relieving Freescale Inc., Freescale Ltd. and certain other Freescale Ltd. subsidiaries of their obligations associated with that liability. A significant portion of our lenders under the Amended 2020 Term Loan were previously lenders under the 2016 and 2020 Term Loans, while some of the funds from the issuance of the Amended 2020 Term Loan were from new lenders. Credit Facility At October 3, 2014, Freescale Inc.'s senior secured credit facilities (the "Credit Facility") included (i) $2,699 million outstanding under the Amended 2020 Term Loan, (ii) $792 million outstanding under the senior secured term loan facility maturing in 2021 ("2021 Term Loan") and (iii) the 2019 Revolver, including letters of credit and swing line loan sub-facilities, with a committed capacity of $400 million. The spread over LIBOR with respect to the Amended 2020 Term Loan is 3.25%, with a LIBOR floor of 1.00%, resulting in an effective interest rate of 4.25% at October 3, 2014. The spread over LIBOR with respect to 2021 Term Loan is 3.75%, with a LIBOR floor of 1.25%, resulting in an effective interest rate of 5.00% at October 3, 38-------------------------------------------------------------------------------- Table of Contents 2014. At October 3, 2014, the available capacity under the 2019 Revolver was $384 million, as reduced by $16 million of outstanding letters of credit. Under the third amended and restated credit agreement as of March 1, 2013 as amended by the Q1 2014 Revolver Amendment and the Q1 2014 Term Loan Refinancing Transaction (the "Credit Agreement"), Freescale Inc. is required to repay a portion both of the Amended 2020 Term Loan and 2021 Term Loan in quarterly installments in aggregate annual amounts equal to 1% of the initial outstanding balance, or approximately $35 million annually. Senior Notes Freescale Inc. had an aggregate principal amount of $2,213 million in senior notes outstanding at October 3, 2014, consisting of (i) $500 million of 5.00% senior secured notes due 2021 ("5.00% Secured Notes"), (ii) $960 million of 6.00% senior secured notes due 2022 ("6.00% Secured Notes"), (iii) $473 million of 10.75% senior unsecured notes due 2020 ("10.75% Unsecured Notes) and (iv) $280 million of 8.05% Unsecured Notes (collectively, the "Senior Notes"). With regard to these notes, interest is payable semi-annually in arrears as follows: (i) every May 15th and November 15th for the 5.00% Secured Notes; (ii) every May 15th and November 15th for the 6.00% Secured Notes; (iii) every February 1st and August 1st for the 10.75% Unsecured Notes; and (iv) every February 1stand August 1st for the 8.05% Unsecured Notes. Hedging Transactions During the third quarter of 2014, we entered into cash flow designated interest rate swap agreements to hedge a portion of our variable rate debt against exposure to increasing LIBOR rates which may exceed the LIBOR floor on the Amended 2020 Term Loan in future periods. These agreements fix the interest rate on a portion of our variable rate debt beginning in 2016 and continuing through 2018. (Refer to Note 5, "Risk Management," in the accompanying Condensed Consolidated Financial Statements for further details of these hedging agreements.) Prior to 2013, Freescale Inc. utilized interest rate swap and interest rate cap agreements with various counterparties as a hedge of the variable cash flows of our variable interest rate debt through 2016. In connection with the refinancing transaction in the first quarter of 2013, under which the majority of our debt essentially became fixed rate debt as long as LIBOR rates remain below the respective LIBOR floors on our variable rate term loans, we effectively terminated these previous agreements and fixed the remaining payment stream. Debt Service We are required to make debt service principal payments under the terms of our debt agreements. As of October 3, 2014, future obligated debt payments are $9 million during the remainder of 2014, $35 million in 2015, $35 million in 2016, $35 million in 2017, $35 million in 2018, $35 million in 2019 and $5,520 million thereafter. As a result of the aforementioned notice of redemption issued subsequent to the end of the third quarter of 2014, an incremental $100 million of principal payments previously obligated in 2020 will be paid in the fourth quarter of 2014. Fair Value At October 3, 2014, the fair value of the aggregate principal amount of our long-term debt was approximately $5,710 million, exclusive of $35 million of current maturities, which was determined based upon quoted market prices. Since considerable judgment is required in interpreting market information, the fair value of the long-term debt is not necessarily the amount which could be realized in a current market exchange. Refer to Note 4, "Debt," in the accompanying Condensed Consolidated Financial Statements for more detail on the notes described in this section. Adjusted EBITDA Adjusted EBITDA is calculated in accordance with the Credit Agreement and the indentures governing the senior secured and senior unsecured notes (the "Indentures"). Adjusted EBITDA is net earnings (loss) adjusted for certain non-cash and other items that are included in net earnings (loss). Freescale Inc. is not subject to any maintenance covenants under its existing debt agreements and is therefore not required to maintain any minimum specified level of Adjusted EBITDA or maintain any ratio based on Adjusted EBITDA or otherwise. However, our ability to engage in specified activities is tied to ratios under Freescale Inc.'s debt agreements based on Adjusted EBITDA, in each case subject to certain exceptions. Our subsidiaries are unable to incur any indebtedness under the Indentures and specified indebtedness under the Credit Agreement, pay dividends, make certain investments, prepay junior debt and make other restricted payments, in each case not otherwise permitted by our debt agreements, unless, after giving effect to the proposed activity, the fixed charge coverage ratio (as defined in the applicable indenture) would be at least 2.00:1 and the senior secured first lien leverage ratio (as defined in the Credit Agreement) would be no greater than 4.00:1. Also, our subsidiaries may not incur certain indebtedness in connection with acquisitions unless, prior to and after giving effect to the proposed transaction, the total leverage ratio (as defined in the Credit Agreement) is no greater than 6.50:1, except as otherwise permitted by the Credit Agreement. In addition, except as otherwise permitted by the applicable debt agreement, we may not designate any subsidiary as unrestricted or engage in certain mergers unless, after giving effect to the proposed transaction, the fixed charge coverage ratio would be at least 2.00:1 or equal to or greater than it was prior to the proposed transaction and the senior secured first lien leverage ratio would be no greater than 4.00:1. We are 39-------------------------------------------------------------------------------- Table of Contents also unable to have liens on assets securing indebtedness without also securing the notes unless the consolidated secured debt ratio (as defined in the applicable indenture) would be no greater than 3.25:1 after giving effect to the proposed lien, except as otherwise permitted by the Indentures. Accordingly, we believe it is useful to provide the calculation of Adjusted EBITDA to investors for purposes of determining our ability to engage in these activities. As of October 3, 2014, Freescale Inc. was in compliance with the covenants under the Credit Facility and the Indentures and met the total leverage ratio, the senior secured first lien leverage ratio and the fixed charge coverage ratio but did not meet the consolidated secured debt ratio. As of October 3, 2014, Freescale Inc.'s total leverage ratio was 4.72:1, senior secured first lien leverage ratio was 3.98:1, the fixed charge coverage ratio was 3.37:1 and the consolidated secured debt ratio was 4.68:1. Accordingly, we are currently restricted from incurring liens on assets securing indebtedness, except as otherwise permitted by the Indentures. The fact that we did not meet one of these ratios does not result in any default under the Credit Agreement or the Indentures. Adjusted EBITDA is a non-U.S. GAAP measure. Adjusted EBITDA does not represent, and should not be considered an alternative to, net earnings (loss), operating earnings (loss), or cash flow from operations as those terms are defined by accounting principles generally accepted in the United States of America (U.S. GAAP), and does not necessarily indicate whether cash flows will be sufficient to fund cash needs. Although Adjusted EBITDA and similar measures are frequently used as measures of operations and the ability to meet debt service requirements by other companies, our calculation of Adjusted EBITDA is not necessarily comparable to such other similarly titled captions of other companies. The calculation of Adjusted EBITDA in the Indentures and the Credit Facility allows us to add back certain charges that are deducted in calculating net earnings (loss). However, some of these expenses may recur, vary greatly and are difficult to predict. Further, our debt instruments require that Adjusted EBITDA be calculated for the most recent four fiscal quarters. We do not present Adjusted EBITDA on a quarterly basis. In addition, the measure can be disproportionately affected by quarterly fluctuations in our operating results, and it may not be comparable to the measure for any subsequent four-quarter period or any complete fiscal year. The following is a reconciliation of net earnings, which is a U.S. GAAP measure of our operating results, to Adjusted EBITDA, as calculated pursuant to Freescale Inc.'s debt agreements for the most recent four fiscal quarter period as required by such agreements. Twelve Months Ended (in millions) October 3, 2014 Net earnings $ 70 Interest expense, net 384 Income tax expense 34 Depreciation and amortization expense(1) 256 Non-cash share-based compensation expense (2) 62 Loss on extinguishment or modification of long-term debt (3) 204 Reorganization of business and other (4) 39 Other terms (5) 10 Adjusted EBITDA $ 1,059 (1) Excludes amortization of debt issuance costs, which are included in interest expense, net. (2) Reflects non-cash, share-based compensation expense under the provisions of ASC Topic 718, "Compensation - Stock Compensation." (3) Reflects losses on extinguishments and modifications of our long-term debt. (4) Reflects items related to our reorganization of business programs and other charges. (5) Reflects adjustments required by our debt instruments, including business optimization expenses, relocation expenses and other items. Future Financing Activities Our primary future cash needs on a recurring basis will be for working capital, capital expenditures and debt service obligations, including debt service principal payments on the term loans. Subsequent to the end of the third quarter of 2014, Freescale Inc. delivered notice of an incremental $100 million redemption of indebtedness to occur during the fourth quarter of 2014. In addition, we expect to spend approximately $15 million over the remainder of 2014 and approximately $15 million thereafter in connection with the reorganization plan initiated during 2012, the closure of the Toulouse, France manufacturing facility and the demolition of the Sendai, Japan manufacturing facility; however, the timing of these payments depends on many factors, including the timing of redeployment of existing resources and compliance with local employment laws, and actual amounts paid may vary based on currency fluctuation. We believe that our cash and cash equivalents balance as of October 3, 2014 of $737 million and cash flows from operations will be sufficient to fund our working capital needs, capital expenditures, restructuring plan and other business requirements for at least the next twelve months. In addition, our ability to borrow under the 2019 Revolver was $384 million as of October 3, 2014, as reduced by $16 million of outstanding letters of credit. (Refer to Note 4, "Debt," and Note 9, "Reorganization of Business and Other," in the accompanying Condensed 40-------------------------------------------------------------------------------- Table of Contents Consolidated Financial Statements for additional discussion of the borrowing abilities and reorganization actions described in this section.) If our cash flows from operations are less than we expect or we require funds to consummate acquisitions of other businesses, assets, products or technologies, we may need to incur additional debt, sell or monetize certain existing assets or utilize our cash and cash equivalents. In the event additional funding is required, there can be no assurance that future funding will be available on terms favorable to us or at all. Furthermore, our debt agreements contain restrictive covenants that limit our ability to, among other things, incur additional debt and sell assets. We are highly leveraged, and this could adversely affect our ability to raise additional capital to fund our operations, limit our ability to react to changes in the economy or our industry, expose us to interest rate risk to the extent of our non-hedged variable rate debt and prevent us from meeting our obligations under one or more of our debt agreements. During the third quarter of 2014, we entered into interest rate swap agreements which effectively fix the interest rates on a portion of our variable rate debt beginning in 2016 and continuing through 2018. In the absence of sufficient operating results and resources to service our debt, or as the result of the inability to complete appropriate refinancings and amendments of our debt, we could face substantial liquidity problems and may be required to seek the disposal of material assets or operations to meet our debt service and other obligations. If we cannot make scheduled payments on our indebtedness, we will be in default under one or more of our debt agreements and, as a result, we would need to take other action to satisfy our obligations or be forced into bankruptcy or liquidation. As market conditions warrant, or as repurchase obligations under the agreements governing our Credit Facility and Senior Notes may require, we and our major equity holders may from time to time repurchase or redeem debt securities issued by Freescale Inc. through redemptions under the terms of the Indentures, in privately negotiated or open-market transactions, by tender offer or otherwise, or issue new debt in order to refinance or prepay amounts outstanding under the Credit Facility or Senior Notes or for other permitted purposes. Further, depending on market conditions, the strategy for our capital structure and other factors, we also may issue equity securities from time to time in public or private offerings. There can be no assurance, however, that any issuance of equity or debt will occur or be successful. Off-Balance Sheet Arrangements We use customary off-balance sheet arrangements, such as operating leases and letters of credit, to finance our business. None of these arrangements has or is likely to have a material effect on our results of operations, financial condition or liquidity. Item 3: Quantitative and Qualitative Disclosures About Market Risk Foreign Currency Risk As a multinational company, our transactions are denominated in a variety of currencies. We have a foreign exchange hedging process to manage currency risks resulting from transactions in currencies other than the functional currency of our subsidiaries. We use financial instruments to hedge, and therefore attempt to reduce our overall exposure to the effects of currency fluctuations on cash flows. Our policy prohibits us from speculating in financial instruments for profit on exchange rate price fluctuations, from trading in currencies for which there are no underlying exposures, and from entering into trades for any currency to intentionally increase the underlying exposure. A significant variation of the value of the U.S. dollar against currencies other than the U.S. dollar could result in a favorable impact on our net earnings in the case of an appreciation of the U.S. dollar, or a negative impact on our net earnings if the U.S. dollar depreciates relative to these currencies. Currency exchange rate fluctuations affect our results of operations because our reporting currency is the U.S. dollar, in which we receive the majority of our net sales, while we incur a significant portion of our costs in currencies other than the U.S. dollar. Certain significant costs incurred by us, such as manufacturing labor costs, research and development, and selling, general and administrative expenses are incurred in the currencies of the countries in which our operations are located. In order to reduce the exposure of our financial results to fluctuations in exchange rates, our principal strategy has been to naturally hedge the foreign currency-denominated liabilities on our balance sheet against corresponding foreign currency-denominated assets such that any changes in liabilities due to fluctuations in exchange rates are inversely offset by changes in their corresponding foreign currency assets. In order to further reduce our exposure to U.S. dollar exchange rate fluctuations, we have entered into foreign currency hedge agreements related to the currency and the amount of expenses we expect to incur in countries in which our operations are located. No assurance can be given that our hedging transactions will prevent us from incurring higher foreign currency-denominated costs when translated into our U.S. dollar-based accounts in the event of a weakening of the U.S. dollar on the non-hedged portion of our costs and expenses. (Refer to Note 5, "Risk Management," in our accompanying Condensed Consolidated Financial Statements for further discussion.) At October 3, 2014, we had net outstanding foreign currency exchange contracts not designated as accounting hedges with notional amounts totaling approximately $89 million. These forward contracts have original maturities of less than three months. The fair value of the forward contracts was a net unrealized loss of $1 million at October 3, 2014. Forward contract losses of $4 million and $3 million during the third quarter and first nine months of 2014, respectively, were recorded in Other 41-------------------------------------------------------------------------------- Table of Contents expense, net in the accompanying Condensed Consolidated Statements of Operations related to our realized and unrealized results associated with these foreign exchange contracts. Management believes that these financial instruments will not subject us to undue risk of foreign exchange movements because gains and losses on these contracts should offset losses and gains on the assets and liabilities being hedged. The following table shows, in millions of U.S. dollars, the notional amounts of the most significant net foreign exchange hedge positions for outstanding foreign exchange contracts not designated as accounting hedges: October 3, Buy 2014 Chinese Renminbi $ 23 Japanese Yen $ 19 Malaysian Ringgit $ 19 Euro $ 9 Hong Kong Dollar $ 3 Foreign exchange financial instruments that are subject to the effects of currency fluctuations, which may affect reported earnings, include financial instruments which are not denominated in the functional currency of the legal entity holding the instrument. Derivative financial instruments consist primarily of forward contracts. Other financial instruments, which are not denominated in the functional currency of the legal entity holding the instrument, consist primarily of cash and cash equivalents, notes and accounts payable and accounts receivable. The fair value of these foreign exchange derivative instruments would hypothetically decrease by $9 million as of October 3, 2014, if the U.S. dollar were to appreciate against all other currencies by 10% of current levels. This hypothetical amount is suggestive of the effect on future cash flows under the following conditions: (i) all current payables and receivables that are hedged were not realized, (ii) all hedged commitments and anticipated transactions were not realized or canceled, and (iii) hedges of these amounts were not canceled or offset. We do not expect that any of these conditions will be realized. We expect that gains and losses on the derivative financial instruments should offset losses and gains on the assets and liabilities being hedged. If the hedged instruments were included in the sensitivity analysis, the hypothetical change in fair value would be immaterial. The foreign exchange financial instruments are held for purposes other than trading. Instruments used as cash flow hedges must be effective at reducing the risk associated with the exposure being hedged and must be designated as a cash flow hedge at the inception of the hedging relationship. Accordingly, changes in the fair values of such hedge instruments must be highly correlated with changes in the fair values of underlying hedged items both at inception of the hedge and over the life of the hedge contract. At October 3, 2014, we had forward contracts designated as foreign currency cash flow hedges with a total fair value of a net unrealized loss of $6 million. These contracts have original maturities of less than 18 months. The following table shows, in millions of U.S. dollars, the notional amounts of the foreign exchange hedge positions for outstanding foreign exchange contracts designated as cash flow hedges as of October 3, 2014: October 3, Buy (Sell) 2014 Hedged Exposure Malaysian Ringgit $ 121 Cost of sales Chinese Renminbi $ 131 Cost of sales $ 34 Selling, general and administrative $ 34 Research and development Japanese Yen $ 52 Cost of sales 18 Selling, general and administrative Euro $ (53 ) Net sales Gains of $1 million and less than $1 million during the third quarter and first nine months of 2014, respectively, were recorded in the accompanying Condensed Consolidated Statements of Operations related to our realized results associated with these cash flow hedges. The fair value of these cash flow designated foreign exchange derivative instruments would hypothetically decrease by $33 million as of October 3, 2014, if the U.S. dollar were to appreciate against all other currencies by 10% of current levels. Commodity Price Risk We use gold swap contracts to hedge our exposure to increases in the price of gold wire used in our manufacturing processes. At October 3, 2014, we had outstanding gold swap contracts designated as cash flow hedges with notional amounts totaling 17,000 ounces. All of these outstanding contracts had original maturities of 15 months or less. The fair value of these gold swap contracts was a net unrealized loss of $2 million at October 3, 2014. During both the third quarter and first nine 42-------------------------------------------------------------------------------- Table of Contents months of 2014, losses of $1 million were recorded in cost of sales related to the realized results attributable to these contracts. Based on expected gold purchases for the next twelve months, a 10% increase in the price of gold from the price at October 3, 2014 would increase our cost of sales by $4 million annually, absent our outstanding gold swap contracts, while increasing the fair value of our gold swap contracts by $2 million. Management believes that these financial instruments will not subject us to undue risk due to fluctuations in the price of gold bullion because gains and losses on these swap contracts should offset losses and gains on the forecasted gold wire expense being hedged. Interest Rate Risk At October 3, 2014, we had total indebtedness with an outstanding principal amount of $5,704 million, including $3,491 million of variable interest rate debt based on LIBOR. All of our variable rate debt had LIBOR floors that were above the current LIBOR rates, and therefore, is effectively fixed rate debt while LIBOR rates remain below these LIBOR floors. A 100 basis point increase in LIBOR rates from their current levels would result in an increase in our interest expense of only $4 million per year, as the rates would remain below the LIBOR floor on the 2021 Term Loan. During 2013, we effectively terminated our previous interest rate swap agreements that hedged exposure through 2016 by entering into offsetting agreements and as such, a change in LIBOR rates would not affect the cash flows under these interest rate swap arrangements because we have fixed the remaining payment stream under these agreements. During the third quarter of 2014, we entered into additional cash flow designated interest rate swap agreements to hedge a portion of our variable rate debt against exposure to increasing LIBOR rates which may exceed the LIBOR floor on our Amended 2020 Term Loan in future periods. These agreements fix the interest rate on a portion of our variable rate debt beginning in 2016. We are required to pay the counterparties a stream of fixed rate interest payments at a weighted average rate of: (i) 1.62% on a notional amount of $1.4 billion in 2016, (ii) 2.43% on a notional amount of $1.1 billion in 2017 and (iii) 2.95% on a notional amount of $800 million in 2018. In connection with these interest rate swap agreements, we will receive variable rate payments from the counterparties based on 1-month LIBOR, subject to a LIBOR floor of 1%, which coincides with the LIBOR floor on the Amended 2020 Term Loan. The fair value of our interest rate swap agreements (including outstanding historical swap agreements and their offsetting swap agreements) was a net obligation of $11 million, which was estimated based on the yield curve at October 3, 2014. A 100 basis point increase in LIBOR rates would increase the fair value of our interest rate swap agreements by approximately $29 million. The fair value of the aggregate principal amount of our long-term debt, exclusive of $35 million of current maturities, was $5,710 million at October 3, 2014, based upon quoted market prices. Since considerable judgment is required in interpreting market information, the fair value of the long-term debt is not necessarily indicative of the amount which could be realized in a current market exchange. A 100 basis point change in LIBOR rates would impact the fair value of our long-term debt by $77 million. Refer to Note 2, "Other Financial Data," Note 3, "Fair Value Measurement," Note 4, "Debt," and Note 5, "Risk Management," in the accompanying Condensed Consolidated Financial Statements for more information about these financial instruments, their fair values and the financial impact recorded in our results of operations. Other than the change to the fair value of our long-term debt, we experienced no significant changes in market risk during the first nine months of 2014. However, we cannot provide assurance that future changes in foreign currency rates, commodity prices or interest rates will not have a significant effect on our consolidated financial position, results of operations or cash flows. Counterparty Risk Outstanding financial derivative instruments expose us to credit loss in the event of nonperformance by the counterparties to the agreements. We also enter into master netting arrangements with counterparties when possible to mitigate credit risk in derivative transactions. A master netting arrangement may allow counterparties to net settle amounts owed to each other as a result of multiple, separate derivative transactions. The credit exposure related to these financial instruments is represented by the fair value of contracts with a positive fair value at the reporting date. On a periodic basis, we review the credit ratings of our counterparties and adjust our exposure as deemed appropriate. As of October 3, 2014, we believe that our exposure to counterparty risk is immaterial. Item 4: Controls and Procedures (a) Evaluation of disclosure controls and procedures. Under the supervision and with the participation of our senior management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15 (e) under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this quarterly report (the "Evaluation Date"). Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded as of the Evaluation Date that our disclosure controls and procedures were effective such that the information relating to the Company, including our consolidated subsidiaries, required to be disclosed in our Securities and Exchange Commission (SEC) reports (i) is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) is 43-------------------------------------------------------------------------------- Table of Contents accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. (b) Changes in internal control over financial reporting. There have been no changes in our internal control over financial reporting that occurred during the last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 44-------------------------------------------------------------------------------- Table of Contents PART II |